Bond yields have dominated the market in 2022 as a result of the Fed raising rates more quickly than many had anticipated. This was partly due to sticker inflation, which is expected to remain high in the foreseeable future. The Fed has already increased interest rates from the zero bound to the current range of 3.00% to 3.25%, and more rate increases are anticipated for the remainder of the year. At the FOMC meeting the following week, we anticipate another rate increase of 0.75%. According to market expectations, the fed funds rate will end the year between 4.25% and 4.50%.
Bond yields have increased this year as bond prices have decreased due to the tighter monetary policy environment. Given that the bond market is currently offering some appealing risk-adjusted yield prospects, we believe that interest rates have reset to a higher trading band and that the outlook for bond returns has improved significantly.
The current yield curve form, as determined by yields on Treasury securities, is particularly intriguing. Shorter-dated maturities have greater yields than longer-dated ones because the yield curve has been inverted. Inversions of yield curves have historically been the exception rather than the rule, and they frequently herald a downturn in the economy. A two-year Treasury bond’s yield was 4.3% as of the time of writing. A 10-year Treasury bond’s yield, by contrast, was 3.9%. Moving further up the yield curve and taking on more duration risk is not now rewarded in the market.
Ultimately, we believe the yield curve will re-normalize and again become upward-sloping, though the timing is uncertain, particularly given the lack of clarity surrounding future Fed policy and uncertainties regarding the economy and inflation. Notwithstanding – and between now and an eventual re-normalization of the yield curve – we believe the current environment bodes well for the relative risk-adjusted performance of Treasury bonds towards the front end of the curve where higher yields are currently on offer. As such, we are emphasizing this portion of the yield curve within our core fixed-income allocations.
At the same time, and with the risk of a recession elevated, we anticipate credit issues may increase over the forthcoming period. We are focusing on higher quality, investment-grade credits within our core fixed-income allocations to protect against potential defaults or credit downgrade risks.
Despite the likelihood of ongoing near-term volatility given current uncertainties, yields within the bond market are more attractive today relative to levels seen throughout much of the last decade. As a result, we have become more constructive on the outlook for core fixed-income returns and believe our bond allocations will generate increased income potential for our clients.
We continue to monitor developments closely and believe our portfolios are well-positioned to continue to meet the long-term goals of our clients. As always, should you have any questions please do not hesitate to contact your Client Advisor.
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