Walking the tightrope
Three things to watch in 2022.
The pandemic persists and changes. Fortunately, vaccines remain powerful tools to counter the variants without growth-destroying shutdowns. Amid the changing pandemic and the uncertainty it presents, below are the three key things to watch in fixed income for 2022.
- Inflation & inflation expectations Will Fed and market expectations that current high inflation will decline in mid to late 2022 be realized? If not, a tantrum-like reset higher in longer-term Treasury yields may occur as deeply negative real yields prompt total-return-oriented investors to sell high quality bonds. We expect, amid elevated uncertainty, that inflation will not fall enough to avoid some sharp upward pressure on U.S. Treasury yields as 2022 progresses.
- The “Pivoting” Fed Chair Powell has pivoted in a hawkish direction. Can the Fed find the sweet spot, tightening just enough to prevent elevated inflation from embedding in long-run expectations without excessively tightening and shortening the economic expansion? We believe the Fed will tighten three times in 2022, taking the top end of the fed funds target range to 1.00%. We don’t know, nor do Fed policymakers, if they will succeed in tightening just the right amount. Only time will tell.
- Yield curve & the Fed terminal rate Typically, the U.S. Treasury yield curve bear flattens as the Fed shifts toward tightening, with smaller increases in long-term than in short-term yields. But recently, long-term U.S. Treasury yields have been declining from already very low levels, implying a historically low Fed terminal rate (stopping point for the rate-hike cycle) somewhere below 2.0%. Perhaps this outcome reflects the limits to how much the Fed can tighten in a heavily indebted, pandemic world. Alternatively, the lower terminal-rate expectations could be proven wrong. We believe the latter, expecting the terminal rate will end higher than current market expectations and limiting how much further the U.S. Treasury yield curve can flatten.