Market Commentary | May 31, 2022

2022 Mid-Year Outlook: Fixed Income

Our theme coming into 2022 was "when the tide rolls out." We were describing the impact that the shift to tighter monetary policies by the Federal Reserve and other major central banks would likely have on markets. After nearly two years of providing ample liquidity to the economy in response to the pandemic, the tide of easy money was beginning to flow out. 

Our view was that the result would be rising interest rates and higher volatility, especially in the riskier segments of the markets. We suggested investors consider reducing duration and start being cautious about the credit quality in their fixed income portfolios. 

The tide has rolled out

You might remember this fellow featured in our 2022 outlook last December—the investor who was caught by surprise when the easy money flowing through markets started to decline. 

: Cartoon image shows a confused swimmer standing in ankle-deep water labeled "easy money."

Illustration by Charlos Gary. © 2021 Charles Schwab & Co., Inc.


On the positive side, our forecast for rising interest rates and increased volatility proved to be accurate. On the negative side, we didn't see it happening as rapidly as it did. We thought it would likely be a more gradual process. But the war in Ukraine sent energy prices spiking, and supply chain problems were more prolonged than expected, causing inflation to spike sharply higher. Central banks responded by ratcheting up their rate hiking plans. In the early months of the year, there was a "reset" in interest rates. 

There has been a parallel shift up in yields in the Treasury market, for bonds with maturities of two years or greater, as markets adjusted to the swift move toward tightening by the Fed. That resulted in a sharp decline in the prices of intermediate- and long-term bonds that are most sensitive to interest rate changes. 

The yield curve has shifted upward this year

The yield curve between three month and 30 year Treasury yields have shifted upward since the end of last year. The three-month Treasury yield was near zero on December 31, 2021, but was about 1% on May 31, 2022.

Source: Bloomberg, data as of 12/31/2021 and 5/31/2022. 
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. Past performance is no guarantee of future results.


In the second half of the year, we look for the yield curve to flatten further as the Fed hikes rates, and for volatility to remain high. However, we believe the bulk of the increase in yields is likely behind us for this cycle and now favor adding duration exposure,1 while continuing to focus on higher-credit-quality bonds. As with any tightening cycle, the risk of recession is rising. 

We estimate that the target range for the federal funds rate will end the year at 2.25% to 2.5%. Ten-year Treasury yields will likely trade in a 2.5% to 3.0% range but end the year closer to the low end of that range. 

Federal reserve policy outlook 

The message from the Fed is loud and clear. It will tighten policy "expeditiously" until inflation comes down. We translate that to mean two more 50-basis-point2 rate hikes at the next two meetings, bringing the upper bound of the federal funds target rate to 2% by the end of July. That would get the rate near the Fed's estimate of "neutral" in the 2% to 2.5% range. After that, it's likely that the pace of rate hikes will slow, as tightening financial conditions should lead to slower economy and lower inflation. 

In addition, the Fed will be reducing the amount of bonds it holds. The current plan is to eventually allow up to $95 billion in bonds ($60 billion in Treasuries and $35 billion in mortgage-backed securities, or MBS) to mature without reinvestment. The plan suggests that the Fed is aiming to cut the size of the balance sheet back to pre-pandemic levels over the next few years. 

The Fed's balance sheet has ballooned to more than $8 trillion

The amount of securities on the Federal Reserve's balance sheet, including Treasury bills, notes and bonds, Treasury Inflation-Protected Securities and MBS, has grown to more than $8 trillion.

Source: Bloomberg. 
Reserve Balance Wednesday Close for Treasury Bills, Treasury Notes, Treasury Bonds, Treasury Inflation Protected Securities (TIPS), and Mortgage-Backed Securities. Weekly data as of 5/25/2022.


While the Fed's plans sound ominous, the markets have already discounted much of the tightening in policy. The futures markets were pointing to a rise in the fed funds rate to as high as 3% to 3.5% until just recently. 

Fed rate hike expectations have declined since early May

Chart shows market expectations for Federal Reserve rate hikes on May 3, 2022 and May 31, 2022. The more recent data reflected expectations for a slower pace of rate hikes.

Source: Bloomberg. 
Federal funds futures implied rate (FFN2 COMB Comdty) using monthly expectations through December 2023, as of 5/3/2022 and 5/31/2022, respectively. For illustrative purposes only. 

However, we are not convinced that the Fed will need to raise rates that high. We believe that the market is underestimating the impact of the Fed's quantitative tightening along with the rise in global interest rates. Reducing the size of the balance sheet combined with a synchronized global tightening cycle can mean a substantial decline in excess liquidity circulating in the global economy. 

Two-year yields are rising in most major countries

Chart shows two-year government bond yields in Germany, Italy, Greece, the UK, Canada and the U.S. Yields have risen in all those countries this year.

Source: Bloomberg. 
U.S. (USGG2YR Index), Germany (GTDEM2Y Index), Italy (GTIT2Y Index), Greece (GTGRD2Y Index), U.K. (GTGBP2Y Index), Canada (GTCAD2Y Index). Daily data as of 5/31/2022. Past performance is no guarantee of future results.


Financial conditions have tightened

By nearly every measure, financial conditions—the ease with which businesses fund their activities—have already tightened significantly since the Fed shifted signaled it would initiate policy tightening. Credit spreads (the yield difference between Treasuries and corporate bonds) have widened, stocks prices have declined, the dollar has moved sharply higher, and real interest rates have moved up into positive territory. 

Aside from the pandemic-induced plunge in March 2020, the Bloomberg U.S. Financial Conditions Index reading is now the tightest since 2018—near the end of the last Fed tightening cycle. 

Bloomberg U.S. Financial Conditions Index

The Bloomberg U.S. Financial Conditions Index was at negative 52 index points as of May 31, 2022. That represented the tightest conditions since 2018, although not as tight as in March 2020, at the beginning of the COVID-19 pandemic.

Source: Bloomberg. 
Bloomberg U.S. Financial Conditions Index (BFCIUS Index), daily data as of 5/31/2022. Y-axis is truncated at -2.0 for scaling purposes. For reference, the low occurred on 3/24/2020 and was -6.33. Note: The Bloomberg U.S. Financial Conditions Index tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.


In addition, real Treasury yields (that is, adjusted for inflation) minus yields on Treasury Inflation Protected Securities (TIPS) generally have moved out of negative territory and are now at the highest levels since 2019 (aside from a liquidity driven surge at the onset of the pandemic.) That means an investor can lock in a positive yield, irrespective of inflation. That's a sea change from the past few years when real yields were negative. 

Rising real yields act to slow the economy by raising the hurdle rate that investors need to achieve over the risk-free (i.e., Treasury) rate. When money is cheap, borrowing and investing in even the riskiest markets can look attractive compared to negative returns in cash. However, as real yields rise, the hurdle rate needed to achieve attractive returns rises. Consequently, speculation and investment tend to slow as real rates move up. 

It's not surprising that the most speculative and highly leveraged assets, which rely on ample amounts of liquidity to support valuations, are showing the biggest declines in the markets. 

Real yields have moved higher this year

Chart shows real yields for 5-year, 10-year and 30-year Treasuries. All have moved higher since January. The real 30-year yield was 67 basis points as of May 31, 2002, while the real 10-year yield was 19 basis points, and the five-year yield was negative 15 basis points.

Source: Bloomberg. 
US Generic Govt TII 10 Yr (USGGT10Y INDEX), US Generic Govt TII 5 Yr (USGGT05Y INDEX) US Generic Govt TII 5 Yr (USGGT30Y INDEX). Daily data as of 5/23/2022. Past performance is no guarantee of future results.


Rising recession risk

As the Fed moves ahead with its "front-loaded" tightening, fears of recession are growing. Based on past tightening cycles, the chances of the Fed achieving a "soft landing" for the economy are not great. In recent history, there have been only two tightening cycles (1994 and 1984) that avoided a decline into recession. 

Even with the rising risk of recession, it's worth noting that each one is unique. The current environment seems most similar to the early 1980s. Inflation was high in large part due to oil price spikes. In response, the Fed raised nominal and real interest rates aggressively. The economy was otherwise relatively healthy, with a solid banking system and consumers who weren't overextended on debt. Nonetheless, there were two steep back-to-back recessions during that time period, from January to June 1980, and from July 1981 to November 1982. Housing and manufacturing experienced sharp declines and the unemployment rate soared to double-digit levels. 

While the Fed is determined to push inflation lower, there's a good chance it won't have to go to the extremes of the early 1980s. Demographic trends are far different with the U.S. population aging. That tends to result in slower growth and inflation. Another key difference in policy this time around is the use of "forward guidance" by the Fed. In the 1980s the Fed provided very little information about its plans to the markets. Consequently, rate hikes often surprised investors, consumers, and businesses—increasing volatility. This time around the markets should be able to anticipate changes, mitigating some of the surprise factor that can create added volatility. 

Currently, the economy is already starting to show signs of slowing down as interest-rate-sensitive industries like housing experience declining sales, manufacturing orders slow, and corporate profit growth flattens—all indicators that point to rising recession risk. 

Plummeting home sales is evidence that Fed tightening is slowing the economy

About 591,000 new single-family houses were sold in April 2022 on a seasonally adjusted annual basis, down nearly 27% from 809,000 in April 2021.

Source: U.S. Bureau of the Census.
New One Family Houses Sold: United States, Units: Thousands, Seasonally Adjusted Annual Rate (NHSLTOT Index). Monthly data as of 5/31/2022.


Importantly, inflation expectations have been declining from peak levels seen earlier in the year as the markets digest the implications of tighter Fed policy. At 2.6%, the 10-year TIPS breakeven level is high, but not that far from the Fed's 2% inflation target. Considering that the current inflation rate is over 8%, that's a good signal that investors don't anticipate the rate of inflation to stay so high for very long. 

TIPS 10-year breakeven level suggests investors don't expect raging inflation

The TIPS 10-year breakeven level was at 2.7% on May 31, 2022.

Source: Bloomberg. 
U.S. Breakeven 10 Year (USGGBE10 Index). Daily data as of 5/31/2022. The 10-year breakeven rate is calculated as the difference between the 10-year Treasury rate and the 10-year Treasury Inflation-Protected Security (TIPS) rate. Market participants use this value as what they believe the expected inflation should be in the next 10 years, on average.


Strategy: Less credit exposure/more duration

We believe that the peak in intermediate- to long-term rates may be at hand. The Fed's signaling of an aggressive tightening policy triggered a major reset in the fixed income markets in the first half of the year. In the second half of the year, evidence of slower growth and easing inflation should mean that yields don't move significantly higher. There is even room for a decline if inflation pressures ease. 

If we're right that the economy slows and inflation expectations ease, the Fed may not need to raise the federal funds rate beyond the 2.5% to 2.75% level. That should mean that intermediate- to long-term bond yields could edge lower. 

Our preferred strategy is to gradually increase duration of bonds in portfolios at these higher yields. However, we favor higher-credit-quality core bonds, such as Treasuries and investment-grade corporate and investment-grade municipal bonds. In most cycles, yields tend to converge near the peak of the federal funds rate for the cycle. In the 3% region, yields have already discounted Fed tightening beyond the neutral rate. 

In past cycles, 10-year yields and the federal funds rate have converged near market peaks

Chart shows the 10-year Treasury yield and the federal funds rate between May 1986 and May 2022. The 10-year yield and the federal funds rate converged at the peaks of federal funds rate tightening cycles that began in 1987, 1999 and 2004.

Source: Bloomberg. 
Effective Federal Funds Rate, (FEDFUNDS) and 10-Year Treasury Constant Maturity Rate, Percent, Monthly, Not Seasonally Adjusted (DGS10). Data as of 5/23/2022. Past performance is no guarantee of future results.


Cautious on credit

We are more cautious on credit risk, however. As the abundant liquidity of the past few years is reduced by central bank tightening, the riskier segments of the market are likely to respond first. Markets demand higher risk premia when the economic outlook changes, and there are low-risk alternatives to obtaining yields. The recent rise in high-yield spreads by over 200 basis points is a sign that the process is under way. We expect that trend to continue into the second half of the year.

Meanwhile, we do see potential opportunities for fixed income investors to benefit from the rise in rates. Yields on many fixed income asset classes have risen sharply since late last year. After years of low yields that drove investors to allocate more to risky investments, income investors can find attractive yields in higher credit quality fixed income. Investment-grade corporate and municipal bonds are offering higher yields than we have seen in several years, and can help investors earn income without excessive risk-taking. 

Yields in fixed income investments are well above dividend yields for the first time in several years

Chart shows yields for a variety of fixed income investments, including high-yield corporate bonds and mortgage-backed securities. All were higher than the yield on the Dividend Aristocrats index as of May 31, 2022.

Source:  Bloomberg, as of 5/31/2022. 
Indexes represented are: HY Corporates = Bloomberg U.S. Corporate  High-Yield Bond Index; b = Bloomberg Emerging Market USD Aggregate Index; Preferreds =  ICE BofA Fixed Rate Preferred Securities Index; IG Corporates =  Bloomberg U.S. Corporate Bond Index; MBS = Bloomberg U.S. MBS Index; U.S. Aggregate = Bloomberg U.S. Aggregate Bond Index; Municipal Bonds = Bloomberg U.S. Municipal Bond Index; Treasuries =  Bloomberg U.S. Treasury Index; and Dividend Aristocrats =  S&P 500 Dividend Aristocrats Index (Dividend Aristocrats). Yields shown are the average yield-to-worst except for the Dividend Aristocrats, which is the average dividend yield. Past performance is no guarantee of future results.


Overall, we look for returns in the second half of the year to be better for fixed income investors now that the market has reset interest rates higher. However, we still look for volatility to remain high as central banks shift away from their easy-money policies.

1 Duration is a measure of the sensitivity of the price of a bond to a change in interest rates. Some people confuse a bond's duration with its term, or time to maturity. However, term is a linear measure of the years until repayment of principal is due; it does not change with the interest rate environment. Duration, on the other hand, is non-linear and accelerates as the time to maturity lessens.

2 One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001. Thus a 50-basis-point change is equal to 0.5% or one half percentage point.