- Global Investment and Multi-Asset Strategist
United Kingdom, Intermediary
Change
The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Fixed income investors just experienced a “once-in-a-career” market correction: a 10% decline in the Bloomberg Barclays US Aggregate Bond Index (the “Agg”) through the first four months of 2022. For most allocators, this sharp downturn came in tandem with a painful equity market sell-off that has produced a -15% return for the S&P 500 Index year-to-date. It’s been rough sledding for traditional assets so far this year.
The forces behind the fixed income correction are by now familiar to market participants: rising interest rates, triggered largely by higher and stickier inflation than expected, and a scramble by the US Federal Reserve (Fed) to play “catch up” — in other words, to rein in inflation before a vicious cycle of surging wages and even higher prices takes hold. What now? I’m still hesitant to call a “top” for how high 10-year US rates might climb (beyond 3%) because the trajectory of future inflation remains highly uncertain, but I see tentative signs that we may be nearing a plateau. Below are four considerations that have me leaning that way.
1. How much monetary policy tightening is already priced in? A lot. As Figure 1 illustrates, according to the Fed Funds futures market, many investors now anticipate that the Fed Funds rate will reach 3.2% by the end of 2023, some 200 basis points (bps) higher than its current level of 75-100 bps. Fed Chair Powell was not particularly dogmatic when asked recently to identify a “neutral” Fed Funds rate, but he cited a range of 2.0%-3.0%. So, at 3.2%, the market apparently believes the Fed needs to pursue more restrictive monetary policy in order to “break inflation’s back.”
2. Is the economy responding to higher interest rates? The economy and markets seem to be reacting more to prospective Fed tightening than to actual tightening. Typically, the real economy responds to higher rates with a lag time of 6-12 months. However, as Figure 1 shows, a bellwether index of financial conditions (including mortgage rates, asset prices, credit spreads, and money supply) has already drifted lower in response to this year’s “rate shock” (i.e., a 150-bp spike in the 10-year Treasury yield). US manufacturing, home sales, and export data have also dropped lately, albeit from strong levels.
3. What will it take for the Fed to step back from tightening? Lower inflation and weaker demand. Last week, Chair Powell said it would likely take several months of lower core inflation for the Fed to retreat from its planned 50-bp rate hikes. Powell also mentioned “financial conditions” as something the Federal Open Market Committee (FOMC) will be watching closely, along with the labor market. Rising unemployment or any hints of growth dipping below trend might cause the Fed to pause on rate hikes.
There could also be a path forward where the market more or less “does the Fed’s work for it.” Indeed, it already has to some extent: Without having even tightened policy much (yet), the Fed’s more hawkish rhetoric has itself helped the fixed income market adapt to the reality of higher bond yields. Plus, a strong US dollar is also disinflationary. To preserve credibility, the Fed may need to meet the market’s already priced-in rate-hike expectations, but tougher financial conditions or falling inflation might give the Fed leeway to pull back from tightening.
4. What could go wrong from here? The Fed is in uncharted territory with regard to monetary tightening given: 1) the gap between current inflation and the Fed’s target; and 2) the use of tightening to pare back the Fed’s balance sheet, simultaneous with outright rate hikes. The Fed’s estimate that its balance sheet “run-off” is equivalent to only 25 bps of tightening seems quite low. Moreover, the Fed’s mistaken assumption last year that inflation would prove transitory delayed the beginning of its rate hikes. As a result of the Fed being “late to the game,” US monetary policy remains accommodative, with real (inflation-adjusted) 10-year interest rates still negative as of this writing.
Inflation is the wildcard: The Fed continues to believe higher commodity prices and supply-chain disruptions from the Russia/Ukraine war and China’s COVID lockdowns will ease. If they don’t, the Fed may decide to tighten policy more aggressively than the market currently expects. Under that scenario, Fed “overtightening” could tip the US economy toward recession, especially if paired with economic and market volatility from ongoing geopolitical turmoil or other sources. On the other hand, if the Fed pulls back and the market doesn’t believe inflation is under control, the Fed’s credibility is at risk.
Figure 1
Investment implications
- Don’t abandon fixed income at these levels. Higher real and nominal bond yields reflect a major market adjustment to a more hawkish Fed. In an environment of decelerating demand and inflation potentially peaking, I think 10-year US Treasuries sporting around a 3% yield represent decent value and should provide some portfolio diversification if the economy falters. Also, the strong US dollar is deflationary and may help attract more foreign asset flows into US bonds.
- Consider diversifying fixed income exposure. Given the uncertain inflation outlook, committing too much capital to long-duration US fixed income may be risky. Diversifying across global bond markets and currencies with flexibility to tweak portfolio duration as needed may be a better strategy. High-quality corporate bonds look relatively attractive, with their spreads around the 70th percentile versus history. Market-neutral alternatives and gold may also help diversify and defend investor portfolios in a risk-off environment.
- Quality is key for equities. Following this year’s equity market sell-off, and with economic recession now a possibility, many allocators are seeking “places to hide.” Defensive sectors and dividend payers look likely to outperform the market amid elevated volatility as the Fed removes liquidity in the months ahead. Longer term, many investors are finding opportunities in high-quality companies with solid balance sheets and growing revenues and profits at potentially attractive entry points — including in less-favored sectors like technology, consumer discretionary, and financials.
1Positive carry is an investment strategy that involves investing borrowed money and then earning a profit on the difference between the return and the interest owed. Investors commonly use positive carry in currency markets.
Expert
Related insights
Showing
of
Insights Posts
The power of local perspective: the long and short of European equity investing
Continue reading
7
min
Article
2025-10-31
URL References
Related Insights
Stay up to date with the latest market insights and our point of view.
Read next
Showing
of
Insights Posts
Chart in Focus: Can this equity bull market last?
Can this current equity bull market last? In this latest edition of Chart in Focus, we focus on the indicators of whether it may come to an end or keep running.
3
min
Article
2025-11-30
What do declining European earnings mean for ECB policy?
European companies have been unexpectedly resilient over the last couple of years. However, the outlook for European earnings could be more challenging than headline numbers suggest. What could this mean for investors?
6
min
Article
2025-11-30
The power of local perspective: the long and short of European equity investing
Dirk Enderlein and Boris Kergall explain why, in their view, the structural changes impacting European equity markets offer active long/short investors a rich source of potential return and diversification.
7
min
Article
2025-10-31
Impact measurement and management: addressing key challenges
Our IMM practice leader describes common impact investing challenges and suggests ways to overcome them.
5
min
Article
2025-10-31
Quality growth — a less volatile sweet spot?
Growth stocks can be volatile, especially when companies fail to meet expectations. However, high-quality growth companies can help mitigate downside risk while still offering potential for long-term outperformance. How can investors find the sweet spot?
8
min
Article
2025-11-30
Ask the fund manager: investing in global small caps
What's the outlook for small caps and why might it pay to take a global perspective?
7
min
Article
2025-10-31
Unlocking the full value potential of stewardship
Yolanda Courtines and Alex Davis examine how corporate stewardship can be a source of value and delve into what investors can do practically to maximise its full potential.LDI Team Chair Amy Trainor explains why she believes a pension risk transfer may, in many cases, not be the best choice for fully funded plans from a cost/benefit standpoint.
5
min
Article
2025-10-31
Decoding impact expectations: best practices for impact investors and companies
We share three recommendations each for impact investors and companies to help them better understand and manage each other's expectations.
6
min
Article
2025-10-31
Strong fundamentals, attractive valuations: Why the time may be right for active biotech investing
From solid fundamentals to supportive macro conditions, learn why our biotech experts believe the industry may be ready to run.
8
min
Article
2025-10-31
Monthly Market Snapshot — March 2023
A monthly update on equity, fixed income, currency, and commodity markets.
Whitepaper
2024-04-30
Monthly Market Snapshot — February 2023
A monthly update on equity, fixed income, currency, and commodity markets.
Whitepaper
2024-03-31
URL References
Related Insights
Chart in Focus: Can this equity bull market last?
Continue readingMultiple authors