NEW YORK (Reuters) — The Federal Reserve’s well-telegraphed plan to raise interest rates by half a percentage point on Wednesday and start shrinking its balance sheet has failed to quell inflation and growth concerns. , prompting bond investors to seek safety by adjusting the duration of their portfolios.
Security trades can mean short or long duration depending on perceived risk, asset managers said.
As the U.S. central bank struggles to stem soaring inflation, fed funds futures, which track short-term rate expectations, have forecast at least three 50 basis point hikes this year, with more than 250 basis points of cumulative increases.
By the end of 2022, the market has priced in a fed funds rate of 2.86%, down from 0.33% currently.
The Fed is expected to pull two legs under the punch bowl, raising rates again and allowing its nearly $9 trillion balance sheet to shrink to $95 billion a month from June, an approach with two fingers that has never been attempted with such intensity.
Ahead of the Fed meeting, many bond investors held onto fixed income holdings for short durations, typically between one and three years, as they hedge against an aggressive pace of Fed tightening. Short-dated bonds, in general, outperform longer-dated bonds in a rising rate environment.
Some investors such as Insight Investment have also gone neutral on duration risk, after being underweight this index for some time.
“There is still a fair amount of uncertainty,” said Jason Celente, senior portfolio manager at Insight Investment.
“Is inflation going to come down? Will the Fed go for a bit higher inflation than in the past? We think that’s probably going to take a little while to materialize.”
As inflation expectations rose and the Fed’s response changed dramatically in recent months, US Treasuries in 2022 sold off sharply. The ICE BofA US Treasury Index has fallen 8.2% this year, on track for its worst performance since at least 1997.
The shorter-duration ICE BofA 1-3-year US Treasury index has performed somewhat better, however, with losses of just 2.7% so far in 2022 and 0.3% for the month of April. .
“The simplest and least risky solution is to simply reduce or eliminate duration risk,” said John Lynch, chief investment officer at Comerica Wealth Management.
He cited yields on money market funds, which have risen from zero to around 0.25% and are expected to continue to rise as the Fed begins its tightening program.
Lynch also recommends ultra-short bond funds, with durations of less than one year, offering better-than-expected returns than longer-duration options, with yields up to around 1.40%.
Risks of price recession
Some are also hedging against the possibility of a recession in the United States. This view gained traction last week as US gross domestic product contracted in the first quarter.
GDP fell at an annualized rate of 1.4% in the first three months of the year, data showed on Thursday.
“The Fed is going to struggle to meet the number of hikes the market has predicted,” said Peter Cramer, head of insurance portfolio management at SLC Management.
“We’re already starting to see a lot of the damage from the market expecting a rate hike. The Fed only hiked once and we’re already seeing a negative GDP rate in the first quarter.”
Cramer also pointed to the US 30-year mortgage rate hitting 5.37% the week of April 22, the highest since 2009, which should crimp housing demand. These rates were slightly below 3% in February 2021.
He thinks the US economy could enter a recession in late 2022 or early 2023, which should prevent the Fed from raising rates aggressively.
Cramer’s call for recession echoed that of Deutsche Bank.
Deutsche, in a research note, said it expects the fed funds rate to top 3.5%, plus an equivalent additional tightening of 0.50% thanks to the reduction in the Fed’s balance sheet. That’s enough, Deutsche said, to push the U.S. economy into a mild recession by the end of next year and possibly several more years, which should help bring inflation down to more desirable levels.
With US recession risks looming, SLC’s Cramer said he was on the defensive in taking a long duration, especially in the three-year portion of the curve.
A long duration reflects expectations that US yields will fall because the Fed will be forced to cut rates.
Cramer also said his portfolio has also increased credit quality and moved away from credit-sensitive sectors.
“There are times when it makes a lot of sense to have a very aggressive interest rate in this or that position, but right now is not one of those times,” said Robert Tipp, head of global bonds at PGIM Fixed Income. .