After two years of ultra-low interest rates, more than ten years of above-average bond returns and over twenty five years since the last time the bond market faced such an abrupt series of rate hikes from the Fed, the recent move in bond market has raised questions about the impact rising rates may have on the path ahead. Here is what we think:
Why are interest rates rising and when will they stop going up?
During the week that began March 20th, the UST10yr yield rose more than 30bps and is now close 100bps higher in 2022. Rising bond yields are responding to the Federal Reserve new monetary policy regime, which began when the US central bank started an interest rate tightening cycle to control inflationary pressures, currently running at a 40-year high and risking disrupt well anchored inflation expectations.
While short-term rates already reflect the Fed tightening cycle, we believe longer-term rates have room to rise. UST2yr reacted faster to the Fed outlook for higher rates in 2022 and the first hike of 0.25% on March 16th. In essence, short-term rates may have already priced in most of the move higher by the Fed, with a tripling in yield on the year and a raise of 75bps in March alone. Long-term rates have also risen sharply on the year; however, we think there is still room for yields to move higher, albeit not with the same intensity of the short rates. We expect the Fed to not only cease bond buying, but also to begin actively reducing its balance sheet from the record USD $9.0 trillion, thus putting further pressure higher on yields. With that said, we believe that any weakening in economic growth and potential geopolitical shocks will exert downward pressure on yields.
Now, the time frame for interest rates to stop rising will be tricky to determine. While inflationary pressures are starting to disrupt well-anchored long-term inflation expectations, leading survey economic data out of the US and Europe are pointing to a decent slowdown in economic activity over the next 6 months or so.
Will higher rates cause a recession?
That is a very hard question to answer. On one hand, higher short-term rates and higher commodity prices will have an impact on the pace of economic growth, but on the other hand, accumulated household savings of more than USD $2.0 trillion should support consumer spending going forward.
Another way to look at this is that higher rates are not the same as high rates. The current “Fed liftoff” began from a very low base (0%) and currently at ~2.5%, the UST10yr yield still well below its 2.95% average of the last 20 years. Undoubtedly, tighter Fed policy is a headwind for economic growth, but is not necessarily a trigger for a downturn. Traditionally, the catalyst for downturns have been popping asset bubbles (tech in 2000, housing in 2008), exogenous shocks (oil shock in 1973, global pandemic in 2020) and restrictive monetary policy (1980, 1981 and 1990).
Current monetary policy is far from suggesting that a recession in imminent; excluding the pandemic shock, the last three recessions began when the Fed policy rates was north of 4%. Said that, a
flattening UST yield curve, higher mortgage rates and tighter financial conditions are some of the red flags on top of our radar.
With rates rising, does it still make sense to have an allocation to bonds? Said differently, is the traditional 60/40 portfolio still relevant?
Yes, bond still serve an important role in portfolios. Even though rates are higher, bond yields are likely to remain low compared to history. As such, bonds will continue to show their value to portfolios by helping buffer against ongoing market volatility coming from geopolitical risks and recession anxiety.
We recommend investors focus on proactive rebalancing and proper diversification across equities and fixed income, maintaining exposure to a range of equity and fixed income asset classes to navigate market conditions ahead.
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