Did you doubt that we were really in a new phase for monetary policy? If so, you probably put those doubts to rest last week.
In December, the U.S. Federal Reserve confirmed that it would double the rate of its asset-purchase tapering, a move that caused markets to price a greater-than-50% probability of a rate hike as early as March. To kick off the New Year, it published the minutes of the December meeting, and revealed that policymakers are considering quantitative tightening soon after the rates “lift-off.”
There appears to be a new determination to get on top of inflation: This would be a much faster withdrawal of liquidity than we saw after the Great Financial Crisis. As a result, 2022 has begun with a notable bond market selloff: The U.S. 10-year real rate has powered through the -0.90% threshold, and the nominal 10-year yield is above 1.70% again. German Bunds could soon offer positive yields for the first time in almost two years.
This sets the stage for our forthcoming first-quarter Fixed Income Investment Outlook.
Rate Hike Risk to the Upside
We think the Fed is right in its urgency on inflation.
We expect inflation to moderate as some factors, such as car prices, begin to ease off. But we also expect that moderation to be shallower and shorter-lived than markets are pricing for, due to persistent pressure from rising wages and housing prices.
We believe inflation could easily remain at 3% or more throughout the year, and we could see more than the three Fed rate hikes currently priced in for 2022 and signaled by the “dot plot.”
That leads to the first two of our four investment themes: defensive positioning in rates, particularly in the U.S.; and maintaining inflation protection.
We expect markets to reprice the Fed’s terminal rate, from 1.75% to something more like 2.25%, as growth and inflation exceed the Fed’s targets. This would likely imply a 10-year Treasury yield of 1.85 – 2.00%.
A repricing of real rates could make Treasury Inflation Protected Securities (TIPS) a more attractive way to gain direct inflation exposure, but at current valuations we prefer cash and floating rates in asset-backed, loan and corporate credit markets.
Robust Credit Fundamentals
As that suggests, we still like credit, albeit a little more cautiously than last year—the third of our four themes.
We see the 2022 hiking cycle as simply an end to emergency policy, and so we think a policy mistake that fundamentally changes the global growth environment is possible, but unlikely.
Outside of China, household and corporate balance sheets remain strong in the major economies. We do not expect defaults to rise above 1% in high yield markets during 2022. While an uptick in mergers and acquisitions could be marginally unfriendly to investment grade spreads, on the whole we expect bond market volatility to come from inflation and policy dynamics rather than credit fundamentals—and therefore provide opportunities to buy the dips.
Value in Emerging Markets
And finally, we are positive on emerging markets debt.
One reason is that it has fallen so out of favor. Emerging markets were hardest hit by the pandemic, given their often under-resourced health systems and their lower capacity for fiscal support. Hard-currency debt is cheaper relative to U.S. and European credit than it has been for years.
Just as important, many emerging economies are already well advanced in the tightening cycle that the Fed is just beginning, and the European Central Bank and Bank of Japan are barely contemplating. Russia doubled its policy rate during 2021; Brazil moved from 2.00% to 9.25%.
It’s no surprise that our views for 2022 are dominated, one way or another, by inflation and central bank policy considerations. Against a backdrop of a resilient, midcycle economy and robust credit fundamentals, we believe these are likely to be the major determinants of fixed income performance. Last week’s news from the Fed merely strengthened the prevailing wind.
In Case You Missed It
- U.S. ISM Manufacturing Index: -2.4 to 58.7 in December
- U.S. ISM Non-Manufacturing Index: -7.0 to 62.0 in December
- U.S. Employment Report: Nonfarm payrolls increased 199,000 and the unemployment rate decreased to 3.9% in December
- Eurozone Consumer Price Index: 5.0% in December year-over-year (core CPI was unchanged at 2.6% in December year-over-year)
What to Watch For
- Wednesday, January 12:
- U.S. Consumer Price Index
- Thursday, January 13:
- U.S. Producer Price Index
- Friday, January 14:
- U.S. Retail Sales