Fixed income perspective

Fixed Income Perspectives

January 14, 2022

U.S. yields respond to hot inflation, policy outlook

What happened

The Consumer Price Index (CPI) report for January saw the U.S. post inflation's highest year-over-year reading in 40 years. January headline CPI hit 7.5%, slightly above the very high expectation that inflation would rise by 7.3%. The “hot” inflation data sparked a powerful reaction in U.S. fixed income markets.

As a result, 2-year U.S. Treasury yields, which are closely related to the Federal Reserve’s (Fed) rate policy, spiked more than 20 basis points (0.20%) to 1.58%. It was the 2-year’s largest single-day increase in more than a decade. The CPI report increased market bets that the Fed would have to raise rates more aggressively to tame inflation, with the consensus now pricing in 6 or 7 rate hikes before year-end (slide 2). Additionally, discussions by some Fed officials advocating for a 50 basis point hike in March applied further upward pressure on the front end of the yield curve.

It also pushed up yields across the rest of the curve as 10-year U.S. Treasury yields broke above 2% for the first time in two-and-a-half years. However, the upward move was more muted beyond the first 5 years, resulting in a significant flattening of the yield curve. Currently, just 41 basis points (0.41%) separate 2- and 10-year U.S. Treasury yields (slide 3). At this point in a recovery, the U.S. yield curve is typically far steeper.

Our take

The flattening of the yield curve presents a significant obstacle to the Fed raising rates as aggressively as the market anticipates. We expect the Fed to take a somewhat slower approach with respect to rate hikes. Instead, we believe the Fed will turn to reducing its balance sheet as a means to help yields rise beyond 5 years and preserve a healthy (i.e. upward sloping) yield curve. We maintain our expectation for yields to rise gradually in the months ahead as a result of hot inflation, sturdy growth, and the Fed’s policy shifts.

While we still favor U.S. equities over fixed income, we continue to value fixed income’s critical role within investor portfolios. Reports of rising Russia-Ukraine tensions on Friday, which pulled the S&P 500 sharply lower while high-quality fixed income rallied, offered a stark reminder of fixed income’s valuable diversification benefits (slides 5-7). Although yields remain low on a historical basis, core bonds frequently act as a ballast in portfolios when riskier assets underperform. Despite their rocky start to the year, fixed income remains a key component to managing risk and protecting principal.

Bottom line

The Fed’s monetary policy transition will continue to inject volatility into global markets, including U.S. fixed income (slide 4). Given our expectations that yields should rise further, we continue to recommend a below benchmark duration to help reduce negative price performance.

The Fed’s plans to reduce policy accommodation has taken a toll on virtually all traditional asset classes simultaneously. Despite U.S. fixed income’s underwhelming start to the year, we maintain our view that exposure to core fixed income plays a valuable role in asset allocation strategies and warrants a place in most long-term investment portfolios. Over longer time horizons, high quality fixed income provides portfolios with better risk-adjusted returns through the benefits of diversification, lower correlation to riskier asset classes, and reliable income.

To read the publication in its entirety, including charts and support, please select the "Download PDF" button, below.

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