- The keys to success for fixed-income portfolios in 2022 may be dynamic positioning in both rates and credit strategy and investing at higher market yields.
- Many fixed-income indexes delivered negative total returns in 2021, in part driven by increases in Treasury yields from the lows experienced in 2020.
- The Federal Reserve (Fed) has signaled that it intends to raise the federal funds rate in 2022.
- For investors considering the impact of tighter monetary policy, a large portion of the pain from rising rates and higher yields has already been priced into markets.
Transitioning to tighter monetary policy
The Fed is getting ready to tighten their belts. After pegging the overnight lending rate set by the Fed between 0 and 25 basis points (bps; 100 bps equal 1.00%) since early 2020 at the onset of the COVID-19 pandemic and liquidity crisis, the Fed has kept monetary policy extremely accommodative through various bond purchase programs. At its December Federal Open Market Committee (FOMC) meeting, the Fed announced it would be accelerating its efforts to first reduce and then remove accommodation from the markets in 2022. The Fed then decided to increase the pace of its balance sheet tapering (the Fed is still purchasing billions of dollars in U.S. Treasury and agency mortgage-backed securities (MBS) each month but will now do so at a lower level) and updated its “dot plot” to indicate expectations of raising the federal funds rate as many as three times in 2022 (see chart). However, despite this seemingly aggressive hawkish pivot, the Fed merely matched what the market had been expecting and for which it had already adjusted for.
In fact, the market has been preparing for action by the Fed throughout most of 2021 (see chart below). When 2021 began, the consensus expectation was that the Fed would raise the federal funds rate only one time by the end of 2023. By December, the market had moved to expecting nearly six hikes by the end of 2023. The updated December dot plot above shows the Fed coming into agreement with what the market had been already pricing in for three months since the FOMC’s prior September meeting.
With the Fed now in line with the market’s rate projections and as investors consider their investment outlook for 2022, one should fully expect federal funds rate increases in 2022—and most likely a few of them. This, however, should also lead many investors to ask the question: How will rising rates and higher yields affect my fixed-income portfolio?
Markets are forward-looking
The good news for fixed-income investors, as we have just described in our introduction, is that markets are forward-looking. By the time the Fed actually takes the step to increase the federal funds rate, market yields will have likely already risen. Chart 3 shows the yields for the 2-year and 5-year Treasury and the effective federal funds rate since 2001. Over the prior two periods of Fed monetary policy tightening, the yields on front-end securities rose prior to the hikes in the federal funds rate. The chart also shows that these yields have already risen materially since September 2021 and that some of the impact of the move higher in yields has already occurred.
Differentiating between rising rates and higher yields
The Fed controls the very short (overnight) rate by setting the federal funds rate and, as previously mentioned, it expects to raise that rate a few times in 2022. The Fed does not, however, have direct control of longer maturity yields and hikes don’t need to translate into 1-for-1 upward movements in long-end yields. Should the Fed raise the federal funds rate three times in 2022, it doesn’t necessarily mean that the yield on the 30-year Treasury, for example, will rise by 75 bps.
2021 saw Treasury yields across the curve begin to “normalize” after achieving decade- or all-time-low levels in 2020. Keeping that in mind and tying markets’ “forward pricing,” one might conclude that, as we begin 2022, a portion of the march higher in yields—especially in longer tenors—may have already occurred. Chart 4 below shows the rise in yields from their 2020 lows up until the September FOMC meeting alongside the change in yields since that meeting.
These changes have resulted in higher all-in yields for fixed-income securities across the curve coming into 2022 than what was on offer in early 2021, which is welcome news. The ability for portfolios to invest inflows or reinvest maturities at these more attractive levels should be additive for performance in 2022. We expect rates to continue to see volatility in 2022 but for the rise in yields to be lower than what was experienced in 2021. For static, investment-grade-only investors, the rise could lead to lower total returns but should present active fixed-income managers with multiple opportunities to add alpha through dynamic rates positioning. We believe these potential opportunities, in addition to the opportunities afforded through credit and sector allocation, leave active fixed-income strategies well positioned as the year begins.
FEDL01 Index is the U.S. federal funds effective rate (continuous series). FEDL01 is a spliced series of the mean-based calculated values of the effective rate (prior to March 1, 2016) and the median-based calculated values.
H15T2Y, H15T5Y, H15T10Y and H15T30Y: Treasury Yield Curves – Displays the range of yields for 2 yr, 5 yr, 10 yr, and 30 year US Treasury Securities.
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