Hawks at the helm: Q2 outlook
As US inflation rises at the fastest pace in four decades, market sentiment has changed abruptly. In a belated attempt to slow rising consumer prices, the Federal Reserve is now expected to tighten monetary policy more aggressively. The probability of a 50 basis point hike in May is now over 80%, followed by another 50 basis point hike in June. As a result, the federal funds rate should end the year at nearly 2.75%, or 250 basis points higher than today.
This abrupt shift in sentiment has created a “nowhere to hide” environment for investors. Almost overnight, the US moved from a zero rate environment to one that anticipates tighter Fed policy for the rest of the year and into 2023, pushing 2-year yields by 160 basis points in a single quarter – their biggest quarterly rise in more than three decades. With such dramatic moves in the market in just three months, we expect interest rates to remain range-bound in the second quarter, with a slight downward tilt.
For the second quarter, we expect 10-year yields to trade in a range of 2.25-2.65%. However, in the longer term, we remain biased towards the probability of rates rising at the end of the year, with the 10-year yield potentially reaching 2.75%. Two-year yields, after hitting 2.5% in the first quarter, almost priced in the Fed’s hawkish outlook as a whole through the end of the year.
While nominal yields at the short and long end of the yield curve have soared, real yields have remained stubbornly negative. As the inflation narrative shifted from a “transitional” post-pandemic shock to a more sustainable view of wage growth and housing inflation, rising breakeven inflation rates (BEI) moved further along the curve, with the 10-year BEI reaching an all-time high of 3.03% in March. After crossing the 3% level, long-term inflation expectations stabilized around 2.84%, converging towards the inflation expectation of 2.6%. We expect inflation to remain high for the next few months, but expect the BEI to pull back in the third quarter on the Fed’s anticipated rate hikes and lower durable goods prices.
As a result, we continue to expect 10-year real rates near zero at year-end, up from the current -30bps, while the 5-year should trend towards -25bps at – 50 basis points versus the current -65 basis points. We had a neutral allocation to TIPS heading into 2022 with the expectation that real returns would rise as post-pandemic bottlenecks begin to ease. However, the unexpected rise in oil prices, economic sanctions against Russia and persistent wage inflation have kept the TIPS total return at -2.5% since the start of the year – the second-best return on securities at fixed income after Senior Loans.
We remain neutral on TIPS, but watch out as the market has already adjusted to the Fed’s abandonment of inflation as a transitory phenomenon. We continue to view the short end of the TIPS curve as particularly rich, with 1- and 2-year real yields at -4% and -2%, respectively.
The real yield curve may be negative, but it remains upward sloping (ie more negative forward than downward). This should not be ignored when attempting to correlate the shape of the yield curve to recessions and the performance of risky assets.
The shape of the yield curve
In the wake of the inversion of the 2-year/10-year curve, the shape and slope of the nominal yield curve has been a persistent point of attention for market professionals.
However, as noted above, the 160 basis point move in 2-year yields in 1Q22 reflects a deeply held belief in the Fed’s commitment to raising rates very quickly. Therefore, the 2-year/10-year curve can send misleading signals (as it did in 1998) when predicting the potential for an impending recession.
Note that the Fed prefers to focus on the 3 months/10 years and 3 months/2 years parts of the curve. While the 2-year predicts market sentiment two years from now, expectations for the realized trajectory can vary. The 3 month takes a shorter term approach. Both the 3m/10y and the 3m/2y slope upward alongside the real yield curve, which is also linked to risky assets and real GDP growth.
The impact of yield curve inversions depends on depth and durability. The longer-term headwind – where the cost of capital becomes higher than the return on capital and thus limits lending and capital formation – is a significant problem. However, given the fundamental strength of the US labor market and US consumption, as well as the solid outlook for corporate earnings, we do not expect a recession in the next 12 months.
Changes to our asset class preferences
We are closing our preferred allocation to senior loans versus US government bonds. We opened this bear rate allocation in May 2020; as interest rates have risen significantly, combined with the tightening of post-COVID credit spreads, we now view this sector as fully valued.
For more commentary, including additional details on our asset allocation preferences as well as our barbell approach within our fixed income portfolio, see Fixed income strategist: Hawks at the helm: 2Q Outlook, published on April 7, 2022.
Main contributors: Leslie Falconio, Barry McAlinden, Kathleen McNamara, Frank Sileo, Alina Golant and Thomas McLoughlin
This content is a product of the Chief Investment Office of UBS.