The Federal Reserve on Wednesday raised its target interest rate of ¼ point, the first hike since 2018. The change in monetary policy posture is not surprising, given the surge in inflation. Nor is it surprising to see the weak performance of fixed income this year, which continues to be valued in the difficult times ahead for the entire asset class.
Almost all types of US bond ETFs are currently posting year-to-date losses (through March 16). Declines range from trivial to steep. Only one of the tickers in our set of ETF proxies for the US fixed income markets shows a gain in 2022: iShares 0-5 Year TIPS Bond (STIP), which holds short-dated inflation-linked Treasury bonds and growing slightly year-to-date – around 0.2%.
Otherwise, bonds across the spectrum are in the red this year. The biggest drop is in long-term US corporates via Vanguard Long-Term Corporate Bond (VCLT), which has fallen 12% year-to-date.
The question is, how long will the headwinds last for the bond market? Using the Fed’s Policy Committee as a guide, fixed income will be under pressure for the foreseeable future. The Federal Open Market Committee (FOMC) yesterday presented its current forecast for the federal funds rate, which rose slightly within a range of 0.25% to 0.50%. By the end of the year, the FOMC expects federal funds to rise to 1.9%, based on the committee’s median estimate. By the end of next year, current forecasts call for an increase in federal funds to 2.8%.
Expected increases are not set in stone and may be adjusted based on incoming economic data. But while the exact timing and extent of the hikes are subject to adjustment, the market is now confident that interest rates will rise overall in the coming months, possibly into 2023 and beyond. . In the words of the central bank policy statement released on Wednesday, the Fed “expects continued increases in the target range to be appropriate.”
For the next Fed meeting (May 4), futures contracts estimate a virtual certainty of another hike, with a moderate upside (61% probability) for another 25 basis point hike versus a 50 basis point hike (39% probability).
Fed Chairman Powell left no doubt about the policy outlook. At yesterday’s press conference, he noted, “We are mindful of the risks of further upward pressure on inflation and inflation expectations.” He added that “the committee is committed to taking the necessary steps to restore price stability” and that “the US economy is very strong and well positioned to manage tighter monetary policy.”
The main driver of policy change is the recent increase in inflation. Using the consumer price index as a guide, inflation continued to climb in February, rising 7.9% over the past year – a 40-year high.
The war in Ukraine is expected to keep inflationary pressures high and therefore a spike in price pressure does not seem imminent. As long as inflation is well above the fed funds target, as it is now, further rate hikes are likely.
A turning point, or at least a break, can be signaled when inflation shows signs of peaking. One way to monitor such an event is to monitor the Treasury market’s implied inflation forecast, based on the yield spread for the less inflation-indexed nominal yields. But as recent shifts on this front suggest, the market continues to price in elevated/rising inflationary pressures.
What else could change the calculation of the current expected path of interest rates? A sharp downturn in economic activity or a recession. Although the risk of a recession in the United States is currently low, this could change quickly, some economists predict.
Among the most bearish analysts on the US economy is David Rosenberg, chief economist at Rosenberg Research. “The Fed is caught in a self-created box because it didn’t move fast enough to raise rates. Now you have to see him move aggressively,” he said. said. As a result, “I think the risk of recession is very high”.
If he’s right, the bond market could take a breather as crowd bias shifts from worrying about inflation to looking for safe havens. It’s a tough way to get positive returns from fixed income, but for now, it may be the only way bonds can avoid negative results.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.