It is perhaps universally accepted that the Federal Open Market Committee (FOMC) is embarking on an interest rate hike cycle in 2022, starting with the March 16 decision. Recent remarks by Federal Reserve (Fed) Chairman Powell to Congress confirm this expectation.
While there are potential negative outcomes with Russia that could change that course by then, we should all hope and expect that the world will not experience these events and a cycle of hiking beginning with a hiking the March 16 is a fatality.
However, in recent days, investors could get a boost seeing yields tumble as expectations about the pace of future rises shift dramatically. The market now expects the FOMC to raise rates about five to six times in 2022, in response to the highest inflation numbers the US has seen in decades. That’s down from an expectation of 6-7 hikes in mid-February in 2022.
With all the volatility in markets and geopolitics, it’s important to remember that the core of the Fed’s dual mandate is what will guide policy. The FOMC is responsible for promoting maximum employment while maintaining price stability. As the world emerges from two years of COVID restrictions, it is important to take stock of our current situation. The employment side of the equation is almost completely back to pre-COVID levels. The U-3 and U-6 broad unemployment rates are in line with 2018 and 2019 levels and, more importantly, are in line with (or possibly even lower than) historical unemployment rate estimates with no acceleration in the rate of unemployment. inflation (NAIRU) from the Fed.
What has changed from 2018 and 2019 is the inflation side of the picture. For the past decade-plus, the FOMC has openly considered letting inflation exceed its long-term target of 2% in the short to medium term, deeming deflation and a liquidity trap to be more significant risks. While we are seeing inflation readings well above target, the current debate is not around inflation versus deflation, but whether inflation will naturally moderate or require policy action. aggressive monetary policy to be corrected.
So far, the monetary policy hawks are winning. The FOMC’s recent dovish argument that high inflation will be transitory seems misguided. As a result, markets now expect a more aggressive Fed than we have seen in some time, with inflation stubbornly forcing the hand of the FOMC. Many economists are forecasting slower growth in the second half of 2022, and there is a risk that the FOMC will continue to raise rates even in the face of lower growth rates.
If inflation does not come down and growth deteriorates, there is an additional risk that the FOMC will raise rates enough to cause a mild recession, an outcome that is not without precedent. A closer look at the yield curve can help us further assess this risk and the implications for bond portfolios.
The following chart illustrates a common interest rate trend that appears to be repeating itself. The black line represents the spread between the 10-year US Treasury and the 2-year US Treasury.
For example, if the 10-year is 1.50% and the 2-year is 0.25%, the 10-2 spread is 125 basis points (bps) – and quite a steep curve, quite different from the current curve which is getting tighter.
10-2 deviation from Fed target rate (higher)
From time to time, the Fed will hike more aggressively than warranted by the market’s economic outlook. The short duration of the curve is directly influenced by the expectations of future FOMC actions and the longer duration of the curve is much more geared towards correctly assessing economic opportunities. Therefore, when there are doubts about the domestic economy as the market anticipates future FOMC hikes, we will see a flat curve. The worst part of a flat curve is a distorted risk/reward relationship.
Essentially, instruments with shorter durations (less risk) pay the investor the same amount as instruments with longer durations. This inevitably results in very short-lived investment activity that is eventually reinvested while the economy is in recession and the entire curve is lower than it was before. Hence the importance of portfolio structure in both steep and flat curves.
Often, the typical bank portfolio will be a scale from ground zero to the longest duration acceptable to the bank’s board and management team. Such a scale has many advantages, especially when liquidity is the main priority. However, in some balance sheets, the focus is on interest income which also supports liquidity.
In this curve flattening environment, we encourage an approach that starts with your entire balance sheet in mind, which includes both short and longer term instruments and a diversity of credit exposures , avoiding concentration in a single sector.
Over the past two years, monetary policy in the midst of the pandemic has brought the lower bound down to zero. As you are probably all too aware, yields across the curve have fallen like a rock to historic lows. It was not uncommon to extend the duration in order to reserve even somewhat acceptable returns. This was evident across the financial sector as institutions gradually lengthened their duration.
Now, with yields returning closer to the historical norm and certainly north of pre-pandemic all-time lows, it is possible to book shorter duration instruments without hurting your interest income, or at least not that much.
As a result, we continue to see the barbell approach to stock picking add value to institutional balance sheets. In fact, given what happened during the pandemic – specifically related to duration – it is possible to tilt the bar towards a 60/40 focus on short-term deadlines with an overall effect of balancing the bar closer to a 50/50 split when the purchases of the past two years are included. Thus, the longer-duration returns are offset by the shorter-duration liquidity, resulting in an agile portfolio that avoids overemphasizing the two-year reinvestment window.
This investment CD from American Express is an excellent example of a short-term spread instrument. Only recently have we seen CDs return to the positive spreads that characterized the sector for much of the 2010s.
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On the longer run of the bar, this Mahtomedi ISD is a GO Unlimited, bolstered by one of the most significant upgrades in the Midwest and offers a tax-equivalent yield of well over 2.00%. The 2.00 coupon for some may be a “starting step” and for others who are more cautious about bonuses it will be a key attribute.
While high coupons protect against market moves such as the first quarter of 2022, lower amortization can also be beneficial, especially when it comes to mortgage-backed securities.
It’s no secret that rising rate environments have generally been difficult for fixed income investors. For many, the knee-jerk reaction is to aggressively shorten portfolio duration, particularly by focusing new investment activity on the short end of the curve. And while it makes perfect sense to continue buying short-lived assets, it’s important that investors don’t completely neglect the long end of their portfolios and stay balanced in their approach.
Find out how UMB Bank’s capital markets division fixed income sales and trading solutions can support your bank or organization, or Contact us be put in touch with a member of the Capital Markets Division team.
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