SUMMARY
The US Federal Reserve's projected short-term interest rate increases in the year ahead will roughly match the largest for any annual period in history. Adding bonds to portfolios now may make sense.
- The Fed’s response to inflation is responsible for the violent speed of the bondholder’s reversal of fortune. The Fed has made one of its most abrupt
about faces
in history. Taken at its word, the Fed will beginrapid
Quantitative Tightening (QT) roughly 2 months after halting Quantitative Easing (QE). - The US central bank’s stance appears to be going from encouraging fiscal expansion to reinforcing a fiscal contraction. Its projected short-term interest rate increases in the year ahead will roughly match the largest for any annual period in history.
- We already see a material slowdown underway in the global economy. The absence of fiscal support this year amid high inflation is now forcing consumer demand to drop. We have accordingly cut our 2022 US growth forecast to 1.9% from 3.5%.
- Rates of 2.5%-3.0% on US government bonds in a period of slower global growth look attractive. And one can imagine rates going lower at some point in 2023. There is a good reason for this: In all seven Fed tightening cycles since 1980, the central bank has sustained its maximum policy rate for only 7 months on average before cutting rates. If the Fed continues to tighten through the slowdown into 2023, the probability of a policy reversal will be very high.
- With recent valuation changes in bonds, we see an opportunity to build
negative correlations
in asset back into portfolios. When bonds are expensive and stocks are, too, asset allocation between them provides fewer benefits. With bonds having repriced so massively, the asset allocation value of bonds has risen proportionately. - In our view, there is a 70% probability of peak rates in 2022. Only in our ‘Robust’ scenario, where the economy actually accelerates, would this likely not be the case.
- Therefore, we believe that adding bonds to portfolios now may make sense. Note that we are talking about government bonds and high-quality corporates. We would not advise taking material credit risk at this point in the market cycle.
