Monetary policy is set to become less supportive in 2022. Here’s what it means for rates and the yield curve.
Three hikes in 2022?
At its December meeting, the US Federal Reserve left policy
rates unchanged, near zero, while signaling a willingness to
hike as many as three times in 2022 to combat inflation.
It also announced an acceleration in the pace of the taper
that could see the asset purchase program end by March.
Once this occurs, the Fed expects to begin raising rates,
with an additional three increases penciled in for 2023
and two more in 2024. This would bring the Fed Funds rate
close to its estimated neutral level, where monetary policy
is neither easy nor tight, of 2.5%.
Surprises are possible, so avoid making big bets on long-duration assets
The direction of long-term Treasury yields depends on how
the Fed responds to current inflation. The Fed is accelerating
its removal of liquidity because inflation has broadened,
which has the potential to push 10-year yields higher. But it
must be careful not to act too aggressively, which could derail
the economic recovery and cause a recession. We think
remaining flexible and willing to adjust duration as the year
progresses is the best course of action.
Figure 1: Rates are up from Covid lows, but are unlikely to reach pre-pandemic highs
Source: Bloomberg, December 2021.
Traditional inflation hedges are expensive
Many of the traditional inflation hedges, including commodities and
Treasury Inflation-Protected Securities (TIPS), are expensive and lock in
negative real interest rates. An alternative way to hedge portfolios for
inflation risk is by remaining defensive with duration and active within
commodity-centric credit exposures.
Tighter financial conditions set the stage for greater volatility
As the Fed begins to withdraw liquidity from the financial system,
we will see tighter financial conditions, meaning wider credit spreads
and greater volatility. This leaves risk assets more vulnerable to shocks.
Finding winners and losers as rates increase puts greater emphasis on
research that can distinguish between the two.
Rethinking the role of US Treasuries in asset allocation
We are heading into an environment in which risk assets – like emerging
market bonds and high yield – are both more expensive and more
vulnerable. Picking the right bonds through credit research becomes
essential in this environment. In addition, allocating to US Treasuries,
despite record-low yields, could provide a buffer against potentially
higher equity and credit risk.
