It hasn’t exactly been smooth sailing for fixed income investors in 2021. Bond yields have ridden waves of optimism and pessimism about the economy for most of the year. The faster-than-expected reopening of the economy from COVID-19 shutdowns early in the year led to a surge in yields during the first quarter, only to be followed by a plunge in the summer as virus cases rebounded. As we close the books on the year, short-term yields have moved up to the highest levels since early 2020 in anticipation of tighter monetary policy, but 10-year Treasury yields have fallen back from the 1.70% level reached in October despite soaring inflation.
Ten-year Treasury yield: Room to rise
Source: Bloomberg. U.S. Generic 10-year Treasury Yield (USGG10YR INDEX). Daily data as of 11/17/2021. Past performance is no guarantee of future results.
2022: Rough waters bring opportunities
We see more rough waters ahead in 2022 but also more potential opportunities for bond investors looking for income. Yields will likely move higher for all maturities with more volatility as the support from easy monetary policy ebbs. The yield curve could go through bouts of steepening from time to time, but the long-term trend is likely to be a “bear flattener,” where yields rise but the difference between short- and long-term yields narrows. Our estimate for the high end of the benchmark 10-year Treasury yield is in the 1.75% to 2.0% range. The biggest uncertainty around our outlook is how central banks—particularly the Federal Reserve—will react to inflation in 2022.
Treasury yield curve has flattened
Source: Bloomberg, data as of 11/10/2021 and 12/31/2020. Past performance is no guarantee of future results.
The tide of liquidity is receding
The one trend that’s clear for 2022 is that the ultra-loose monetary policies pursued by central banks since the onset of the pandemic are ending. Policy rates have already begun to rise in major emerging market countries in response to rising inflation and steep currency declines. Among the developed markets, Norway and New Zealand have raised rates, while Canada recently ended its bond buying program. Whether the pace is fast or slow, the overall trend is towards “less easy” monetary policy around the globe.
Two-year global bond yields, year to date
Source: Bloomberg. Two-year bond yields, U.S. (USGG10YR), Germany (GTDEM10Y), France (GTFRF10Y) U.K (GTGBP10Y). Data as of 11/10/2021.Source: Bloomberg. Bloomberg Barclays U.S. Aggregate Bond Index (LBUSYW Index) and Bloomberg Barclays Global Aggregate Ex-USD Bond Index (LG38YW Index). Daily data as of 11/10/2021. Past performance is no guarantee of future results.
Less easy money circulating should mean higher interest rates and a decline in the relative value of risk assets, but the effects depend on the pace and magnitude of the policy shift.
When central banks tighten policy quickly, the yield curve tends to flatten on expectations that a reduction in credit flowing to the economy will slow growth. When central banks are slow to tighten policy, the yield curve tends to steepen as it allows inflation pressures to build. For riskier segments of the fixed income markets, like high-yield corporate bonds, a series of fast rate hikes would likely cause a sharper decline in prices than a slow pace since it would signal the potential for a sharper slowdown in growth.
Federal Reserve policy outlook: Slow runoff
To date, the Federal Reserve has signaled only a modest shift in policy. It is beginning to taper its bond purchases, but members of the Fed’s policy-making arm, the Federal Open Market Committee (FOMC), are split on when an initial rate hike might occur. Based on guidance from the Fed, it will reduce its bond purchases by $15 billion per month in total, cutting its Treasury purchases by $10 billion and its mortgage-backed securities by $5 billion. At that pace, the Fed will likely have completed the taper by June.
We doubt that tapering itself will have much impact on bond yields since it has been widely communicated to the market. Moreover, the decline in Fed purchases of Treasuries should be offset by a decline in Treasury issuance in 2022, so there won’t be excess supply for the market to absorb relative to this year.
Treasury issuance forecast
Note: The forecast used the Congressional Budget Office's forecast for the U.S. deficit and assumes The Federal Reserve tapers by $10B/month for Treasuries from November 2021 to May 2022, then reinvests income for the remainder of 2022.
Source: Bloomberg & The Congressional Budget Office. The Federal Reserve Balance Wednesday Close Treasury Securities and Total U.S. Marketable Debt Outstanding (FARWUST Index, DEBPMARK Index) as of September 2021. The Congressional Budget Office's Debt Projections as of July 2021.
Tapering isn’t tightening. As long as the Fed is buying bonds, it is still running a loose monetary policy. Interest income earned on the bonds, as well as maturing bonds, will continue to be reinvested, and its balance sheet will continue to grow. It’s just a “less easy” policy.
Source: Bloomberg. Federal Reserve Balance Sheet Securities Held Outright: Treasuries & Mortgage-Backed Securities (FARWUST Index, FARWMBS Index). Monthly data as of 10/29/2021.
Once tapering is over, the Fed will likely shift into tightening mode, assuming the recovery is on track and inflation is still elevated. Currently, the market is pricing in a high probability of two rate hikes in 2022 and three more in 2023. That’s well ahead of the Fed’s most recent estimates, which indicate a slower path of rate hikes.
The Fed’s view of the path of rate hikes vs. the market’s view
Note: The 12/15/2027 eurodollar futures rate was used for the Longer-Run market rate.
Source: Bloomberg. Fed estimate as of 9/22/2021. The market estimate of the Fed funds using eurodollar futures (EDSF). As of 11/10/2021.
Despite market expectations for a series of rapid increases in rates over the next two years, it’s notable that it is pricing in a lower longer-run rate for federal funds than the Fed. A low estimate of this “terminal rate” suggests investors don’t believe economic growth will be strong enough on a sustained basis to warrant a policy rate much above 2% in this cycle, which is slightly lower than the previous cyclical peak in 2019 and far below the 5.25% levels seen in 2006.
Our expectation is that the Fed will take a gradual approach to tightening monetary policy as long as inflation expectations do not remain significantly above the 2.5% to 3.0% level. Since it adopted its “flexible average inflation targeting” policy in the summer of 2020, the Fed has emphasized its willingness to let inflation overshoot 2% for a period of time in order to allow more time for the unemployment rate to fall. Nonetheless, several Fed officials have indicated concerns about inflation recently. Even Fed Chair Jerome Powell indicated that inflation has lasted “longer than expected” and that the Fed would favor raising rates if there are “serious risks of higher inflation expectations.”
Consequently, we are watching two key indicators—inflation expectations and the employment-to-population ratio. Currently, inflation expectations have risen, but mostly for shorter time horizons. Since the September FOMC meeting, breakeven rates in the Treasury Inflation-Protected Securities (TIPS) market have spiked up for one- and two-year maturities relative to long-term maturities. Breakeven inflation rates are the difference between the yield of a TIPS and the yield of nominal Treasury of similar maturities. With short-term breakeven rates higher than long-term breakeven rates, the market is pricing in declining inflation rates over the long run compared to today’s elevated readings.
TIPS breakeven curve implies higher short-term than long-term inflation
Source: Bloomberg, as of 11/10/2021. The breakeven inflation rate is the difference between the yield of a TIPS and the yield of a nominal Treasury with a comparable maturity; it is the rate that inflation would need to average over the life of the TIPS for it to outperform a nominal Treasury.
On the employment outlook, there is still a significant gap to be filled to recover to pre-pandemic levels. There are about 4.5 million fewer people working now than in late 2019. Many different explanations for the relatively slow pace of job growth relative to job openings are possible —health concerns, child-care issues, shifts in industries seeking workers, and early retirements. Some at the Fed, including Chair Powell, are inclined to allow more time for the job market to recover, while others don’t expect the supply of labor to reach pre-pandemic levels.
We are watching the employment-to-population ratios as a guide to the Fed’s response. The ratio for prime-age workers—those between 25 and 54—is the most significant, because it captures the group that historically has had the highest engagement in the workforce. Closing the gap for this group would open the door to Fed tightening.
Source: Bureau of Labor and Statistics. Civilian Employment-Population Ratio (USERTOT Index), Employment-Population Ratio - 25-54 Yrs. ("Prime Age" (USER54A Index), U.S. Recession Index (USRINDEX Index). Percent, Monthly, Seasonally Adjusted. Data as of 10/31/2021. Shaded areas represent U.S. recessions.
One complicating factor for estimating the Fed’s “reaction function” is the potential for significant turnover at the FOMC. Powell’s term is up in February and to date, he has yet to be renominated. Similarly, Vice Chair Richard Clarida’s terms is ending in 2022 and it isn’t clear who will take that role. Between terms that are ending and retirements, there could be as many as four new faces at the FOMC.
After the flood
We estimate that 10-year Treasury yields could rise as high as the 1.75% to 2.00% region, based on our view that the economy will grow at a relatively fast clip in 2022. Despite setbacks due to supply constraints for many goods, the drivers of economic growth—consumer spending and business investment—look poised to stay firm. Consumers have high levels of assets, the job market is strong, and wages are rising. Corporations have record amounts of liquid assets, and strong earnings, which should fuel investment and hiring. Banks are flush with cash to lend, and fiscal policy is likely to contribute to growth, as well. Financial conditions—the ease with which companies and individuals can obtain funds—are very easy. Historically, when conditions are very loose economic growth is above trend in the following twelve months.
Financial conditions are very loose
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. The Y axis is truncated at -2.0 for scale purposes. For reference purposes, 2020 low was -6.335.
Source: Bloomberg. Bloomberg U.S. Financial Conditions Index (BFCIUS Index), daily data as of 11/10/2021.
As the effects of the pandemic fade and central banks exit their extremely loose policies, we expect yields to return to levels more consistent with potential economic growth. Potential gross domestic product (GDP) is the level of sustainable output that could be achieved given all of the resources in the economy today. The Congressional Budget Office (CBO)’s forecast is for potential GDP to rise in 2022, thanks in large part to the strong dose of fiscal stimulus provided during the COVID downturn. With the economy poised for stronger growth, we expect the 10-year Treasury yield to move up to as high as 2%. Over the long run, potential GDP has a strong relationship with 10-year Treasury yields.
Historically, 10-year Treasury yield has tended to track potential GDP
Source: Bloomberg. Congressional Budget Office Potential Nominal GDP Year over Year and U.S. 10-Year Treasury Yields (USGG10YR Index). Quarterly data as of July 2021. Past performance is no guarantee of future results.
Similarly, we expect a rise in yields to close the gap with inflation expectations. Real yields—nominal adjusted for inflation expectations—have been negative since the onset of the pandemic. Even with easing inflation pressures next year, yields may need to move higher to close the gap, because negative real yields don’t make much sense in an economy growing at a healthy pace with rising inflation.
Real yields remain deeply in negative territory
Source: Bloomberg. US Generic Govt TII 10 Yr (USGGT10Y INDEX) and US Generic Govt TII 5 Yr (USGGT05Y INDEX). Daily data as of 11/10/2021. Past performance is no guarantee of future results.
Widening credit spreads is another likely outcome of declining liquidity in markets. With short-term interest rates set at zero, investors have been increasingly willing to take on more risk to find attractive yields. As central banks begin to raise rates, the prospect of potentially slower economic growth combined with higher risk-free rates could mean that riskier asset classes underperform as investor preferences shift. If the Fed takes a patient approach to tighter policies, riskier bond investments may hold their value, but a faster pace of rate hikes could result in more volatility, wider credit spreads, and lower prices.
Opportunities as the tide rolls out
As the tide moves out on the ultra-easy monetary policies of central banks in 2022, we suggest investors look for opportunities to add duration in their portfolios. It may be tempting to wait for the Fed to begin raising short-term rates to buy intermediate- or long-term bonds, but based on our research that may not be the best approach. In the past three cycles of Fed tightening, 10-year Treasury yields have fallen from interim peak levels in the six to 12 months prior to the initial rate hike.
Markets are forward-looking and the expectation that the Fed may engineer a slowdown in the economy is already on the radar for many investors. In 2022, the reaction of central banks to inflation is likely to be the key factor to watch.
The market has anticipated Fed rate hikes in most cycles
Source: Bloomberg. U.S. Generic 10-year Treasury Yield (USGG10YR INDEX), using weekly data for the specified time periods. Weekly data as of 11/10/2021. Past performance is no guarantee of future results.
We will be looking for opportunities to add to intermediate- and long-term bond holdings as yields move higher. While there may be periods when the yield curve steepens, long-term demand for low-risk bonds remains strong. Aging populations around the globe are driving up savings and the demand for safe yields. Pension funds, insurance companies, and other long-term investors should continue to invest in long-term government bonds to offset their liabilities. Bond ladders or barbells can be effective strategies for averaging into higher yields over time.
For 2022, we suggest a more careful approach to the riskier segments of the fixed income markets, such as high-yield corporate and emerging-market bonds. While current conditions are still positive, valuations appear stretched and vulnerable to a shift in the outlook for the economy.
Finally, we are keeping an eye on the U.S. dollar. Over the past few years, the dollar’s strength has resulted in underperformance by international developed country bonds. Relative interest rate differentials still look supportive to the U.S. bond market, but if global economic cycles and policy rates become more synchronized, the outlook could change. We remain cautious on emerging-market bonds going into 2022, however, due to the combination of weakening currencies and high inflation.
In sum, we expect another wave up in bond yields in 2022 as central banks around the world shift away from the very easy policies of the past few years. With the pandemic-era policies ending, investors should be prepared for shifting tides and the risks and opportunities they present.