HOLD - As the Fed moves into action, bond portfolios need agility

In a world of rapidly escalating prices, Russia’s invasion of Ukraine has exacerbated inflationary pressures. We have seen a direct impact on energy and a broad swath of agricultural commodities, and are likely to see a broadening of price pressures.

Supply chain bottlenecks, another significant source of inflation over the past year, are likely to worsen as a result of sanctions against Russia. And while the world has been focused on the terrible conflict unfolding in Ukraine, another Covid-19 outbreak in several cities in China has stymied economic activity, leading to further disruptions. Meanwhile, US house prices continue to rise at a rapid pace. Given these developments, it has become plain to even the most casual observer that monetary policy in most major economies is behind the curve.

The rapid rise in inflation is staggering. In February 2021, the headline CPI inflation rate in the US was only 1.7% year-over-year. It rose steadily over the ensuing months to 5.4% in June 2021. As inflation remained stubbornly above target and the unemployment rate continued to fall, the Fed made a substantial pivot and began to prioritise fighting inflation over supporting growth. But there was still substantial uncertainty as to how aggressively the Fed would act.

That is no longer the case. As we all know, at the recent Fed meeting on 16 March, with inflation at a 40-year high of 7.9%, the Fed hiked interest rates by 25 basis points (bps). Chair Jerome Powell, in subsequent hawkish comments, made it very clear that the Fed was going to do what it takes to try to reduce inflation. The Fed’s latest projections indicate that it may raise rates above its estimated long-term neutral rate of 2.4% by next year. (The neutral rate is a theoretical federal funds rate at which monetary policy is considered neither accommodative nor restrictive.)

Powell appeared to have high confidence that the US economy can not only withstand but flourish under tighter monetary policy. This indicates to us that the Fed does not seem concerned about the potential impact to growth that could come from tightening financial conditions. As such, barring a major fundamental shock, I expect that the Fed will continue on its tightening path for the rest of 2022. Markets are currently pricing in about eight additional 25 bps rate increases over six scheduled Fed meetings in 2022. The market now expects at least two 50 bps hikes in the coming meetings and, if inflationary pressures stay persistent or rise from today’s very high 7.9%, the Fed could easily continue at that pace for longer.1

Inflation is being driven higher by several components

Data as at 10 March 2022. Source: US Bureau of Labour statistics

As at 23 March 2022

With growth already slowing following the 2020 stimulus and economic recovery, I believe that hawkish monetary policy and tighter financial conditions will further reduce growth expectations. We have seen a compressed economic cycle in the COVID/post-COVID period, progressing from recession, to early-, to mid-cycle in less than 12 months. Whether the next economic slowdown turns into a mild or more significant recession will depend to an extent on the pace of Fed tightening.

Over the past six months, valuations have declined from ultra-rich levels across fixed income sectors. I still view them to be slightly expensive given the rise in implied market volatility and the Fed’s determination to bring down inflation. At the same time, as when prices move to adequately reflect the uncertain environment, we are using bouts of market volatility to selectively add to riskier positions at more attractive levels.

Treasury Inflation-Protected Securities

Valuations of Treasury Inflation-Protected Securities (TIPS) will also depend to a large extent on the pace of Fed tightening. Market participants are pricing rising inflation risk premia (a measure of the premium investors require for the possibility that inflation may rise or fall more than expected over the period in which a bond is held) into bonds. Breakeven inflation on five-year TIPS has risen from 3.0% to around 3.7% this year, the highest reading since the launch of the asset class in 1997. To the extent that inflation remains persistently high, short- maturity TIPS may benefit. However, long-maturity TIPS anticipate inflation down the line and must consider the Fed’s growing commitment to bring down inflation and the deflationary impact of recessions that may occur in the coming decades.

These risks can often outweigh high short-term inflation readings. We currently favour short-duration TIPS, although we will be opportunistic along the maturity spectrum.

Credit fundamentals remain strong

Although the macroeconomic backdrop is uncertain, the fundamentals of US credit are quite healthy and improving in aggregate. Broadly speaking, as the economy continues to recover from the 2020 COVID-19 shock, company fundamentals have improved since the height of the Covid-19 crisis and are still in good shape. Corporate cash balances remain high and default rates are near record lows. There are also many credits that are being upgraded from high yield to investment grade (BBB/Baa and above), the so-called “Rising Stars.” So, from a bottom-up perspective, we are broadly positive on the fundamentals for corporate bonds.

The challenge for credit is the broader macroeconomic environment. When volatility rises and economic growth slows, the market needs to price in the greater risk of falling equity prices and wider credit spreads as investors become more risk-averse.

In addition, US investment grade corporate bonds’ longer duration is also an important factor. The duration of the investment-grade credit universe is around nine years, which is very high by historical standards. This compares to a duration of around 6.5 years for the Bloomberg US Aggregate Index, a broad measure of the US investment-grade, fixed-rate bond market, and a close to seven-year duration for the US Treasuries component of the index. If investors continue to gravitate toward shorter duration sectors such as bank loans in expectation of rising rates, this may continue to weigh on US corporate bond spreads.

Despite these challenges, investment-grade credit provides a lot of opportunity. Inflation readings will be critical in the next few months. Should inflation come down, interest rates may remain in the current range and credit spreads could tighten. On the other hand, if the inflation rate continues to climb and the Fed indicates a more aggressive policy than is currently priced in by the market, I expect credit spreads to widen further. At the time of writing, the Bloomberg US Corporate Bond Index, a measure of the investment-grade, fixed-rate taxable corporate bond market, has a spread of around 125 bps over US Treasuries2. I believe these valuations are reasonably attractive if the US economy avoids a recession, but not yet cheap. In a recessionary environment, I would expect spreads to widen further to the range of 150 bps to 200 bps.

As spreads moved closer to pricing in recessionary levels, we added selectively to high-quality credits and have moved from an underweight to a neutral position in investment-grade corporate bonds. If spreads continue to widen and more fully price in the risk of a recession, I would view it as a buying opportunity. In our portfolios, we will look to build positions in credits where our research analysts believe fundamentals are resilient and improving. Credits emerging from high yield into investment grade are also an attractive hunting ground.

Bottom line

The fixed income team expects the Fed to remain focused on taming inflation from current high levels even at the risk of dampening economic growth. At the 16 March meeting and in subsequent comments, Powell gave clear signals that the central bank is willing to take a more hawkish stance, and that it will remain agile and calibrate its actions based on monthly inflation readings. TIPS currently represent greater value in the shorter maturities, although we intend to invest opportunistically along the maturity spectrum. We added to high-quality corporate bonds as valuations declined, but we remain patient and will look to add select high-quality opportunities should valuations better reflect the current level of risk and volatility in the market.

Pramod Atluri is a fixed income portfolio manager at Capital Group. He has 23 years of investment industry experience and has been with Capital Group for six years.

 2 As at 21 March 2022. Source: Bloomberg

Statements attributed to an individual represent the opinions of that individual as of the date published and may not necessarily reflect the view of Capital Group or its affiliates.