1st Quarter 2022 Fixed Income Review
• Q1 fixed income markets experienced significant negative performance as fixed income assets fell in price and yields rose
• The FOMC hiked its Federal Funds target range by 25bps and concluded its ongoing asset purchase program
• Inflation soared to levels not seen in forty years due to disrupted supply chains and product and materials shortages with the reopening of the economy as well as geopolitical tensions arising from the Russian invasion of Ukraine
• Portions of the U.S. Treasury yield curve “inverted” putting many on recession watch
• Despite world bond yields rising, U.S. Treasury yields are among the highest in the developed world and continue to attract foreign buyers
The first quarter of 2022 was an extraordinary period for fixed income assets both domestically and overseas with negative performance in all sectors surpassing even Q1 2020 at the onset of the COVID outbreak. Domestically, losses were primarily driven by a lack of clarity regarding the eventual endpoint for interest rate hikes as well as the timing of plans to reduce the Fed’s multitrillion dollar balance sheet. The Fed’s balance sheet is a portfolio comprised mostly of Treasuries and mortgage-backed securities (MBS) purchased through numerous programs put in place to hold down interest rates and stimulate economic conditions during the pandemic.
Below are select Bloomberg fixed income index returns through Q1 2022:
Liftoff
U.S. monetary policy embarked on a new phase in Q1 2022. The Fed’s balance sheet ceased expanding, and Fed Chair Jerome Powell announced the first 25bps Fed Funds Rate hike since 2018 at the Federal Open Market Committee’s (FOMC’s) March meeting. At the time, information released indicated that FOMC members expected an average of 6 additional 25bps hikes during the year. Expectations soon changed, as numerous public comments made by Fed members in days following the meeting indicated they were prepared to act more aggressively, if necessary, in their efforts to curb inflation.
At the time of this writing, CME’s FedWatch tool, a widely used rate indicator, projects 50bps hikes at the next three consecutive FOMC meetings, starting in May, with three more 25bps hikes later in the year. Following this path would bring the range for Fed Funds from the current 0.25-0.50% to 2.50-2.75% by the end of 2022, a much faster pace than the previous tightening cycle.
It is important to remember that although the Fed has initiated a much-anticipated tightening cycle, monetary policy remains quite stimulative, just comparatively less so. Current projections for the long-term neutral level of Fed Funds are between 2.375-3.00%, so any level below this range is projected to stimulate the broader economy and any level above is projected to be restrictive. Additionally, the overhang of the Fed’s $9 trillion balance sheet has, in effect, suppressed longer dated Treasury yields. This condition is not expected to dissipate until the balance sheet has been adequately “unwound,” a term used to describe the run-off of maturities not being replaced in the portfolio. Further details about the unwinding process will be provided through FOMC notes and upcoming meetings during Q2. They will be closely scrutinized by Fed watchers and investment managers.
Yield Curve Inversion
The 10-year U.S. Treasury ended March with a yield of 2.32%, representing an upward move of more than 80bps during the quarter. The 2-year U.S. Treasury Note closed Q1 with a yield of 2.31%, a whopping 163bps yield increase over the same period. The yield differential between these two bonds also narrowed significantly, even “inverting” at one point during the recent week.
Historically, inversions of the Treasury yield curve have been a fairly reliable presage to recession, especially in instances where the 2-year yield exceeds the 10-year yield for a sustained period. The chart below offers a good visual showing recent periods of recession being preceded by inversions of 2-year and 10-year Treasury yields (shaded areas indicate recessions). Interestingly, there are numerous economists who presently believe “this time may be different” as U.S. monetary policy has acted to artificially suppress Treasury rates for so long.
The FOMC updated predictions for GDP, inflation, and unemployment in March. GDP is currently expected to be 2.8%, unemployment to be 3.5%, and core Personal Consumption Expenditures Index (PCE) to be 4.1% at year-end 2022. Notably, the core PCE, the central bank’s preferred measure of inflation, continues to hover well above the FOMC’s inflation target of around 2%, rising to 5.4% annualized through February 2022.
Overseas
Foreign bond yields increased materially during Q1 as several foreign central banks followed the Fed’s lead and began to telegraph tighter monetary conditions in response to inflationary pressures. Globally, negative yielding debt outstanding dropped substantially from almost $18 trillion in December 2020 to around $2.5 trillion at the end of Q1 2022.
Below are 10-year bond yields from several foreign countries (sorted from low to high) as of the end of the first quarter 2022. The wide disparity between the yield of the German Bund (the German ten-year note – often considered a proxy for European yields) at 0.54bps compared to the U.S. ten-year note at 2.32% is indicative of differing economic conditions and divergent central bank monetary protocols. The high relative yield of U.S. Treasuries and other high-quality domestic fixed income sectors continue to draw a great deal of support from foreign buyers.
“Something’s Gotta Give”
Domestically, inflation is at a forty-year high and real interest rates (the return realized above the rate of inflation) are quite negative across the board for investment grade fixed income assets. Along with broad diversification we have emphatically recommended maintaining a shorter duration and higher liquidity in fixed income portfolios to position for higher investable rates.
n the meantime, tough talk from an increasingly hawkish Fed and geopolitical uncertainties have served to increase outflows from fixed income mutual funds in recent weeks adding to volatility and impeding liquidity in certain sectors of the market, even Treasuries.
We expect first quarter seasonal weakness and a “risk-off” environment will generate investment opportunities in many non-mainstream, but attractive, segments of fixed income. Further, the shorter maturity sectors of the market already reflect a very aggressive path for the normalization of interest rates giving short duration buyers a significant pick-up in yield over money markets and cash equivalents.
As indicated in our yield curve comments earlier, longer dated instruments already appear braced for an economic downturn- truly a conundrum. Although we will continue to monitor the markets closely, at present, we view these conditions as an opportunity to “fill-in” existing portfolios shortening overall duration and adding near-term liquidity.
Although positive nominal rates may still be available in higher risk sectors of fixed income, taking current and near-term inflationary measures into account, U.S. real rates on higher quality fixed income are generally negative. For taxable accounts, tax exempt municipal bonds appear attractive as the asset class has cheapened materially relative to comparable Treasury yields due to significant mutual fund outflows during Q1.
We hope you will contact your portfolio manager, or any member of our fixed income team, to discuss our thoughts on fixed income, and to learn more about opportunities we believe are both appropriate and timely.
Not Investment Advice or an Offer | This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent
company of Argent Trust, Heritage Trust and AmeriTrust.
For more information about the commentary found in this newsletter, please contact: Sam Boldrick: sboldrick@argenttrust.com or Hutch Bryan: hbryan@argenttrust.com
