- Global Investment and Multi-Asset Strategist
Singapore, 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
Factors to consider when allocating to US small-cap stocks
Continue reading
18
min
Whitepaper
2026-05-31
URL References
Related Insights
Stay up to date with the latest market insights and our point of view.
Read next
Showing
of
Insights Posts
Rapid fire questions with Tim Manning
In this edition of our "Rapid Fire Questions with Portfolio Managers" video series, Tim Manning shares his views on 3 key questions on US equity market outlook.
2
min
Video
2025-12-31
Concentrated markets: Implications for active management, manager research, and multi-manager capital allocation
Members of our Fundamental Factor Team share research insights on the portfolio impact of benchmark concentration and highlight tools that may help, including extension strategies, passive-share analysis, and index-completion approaches.
18
min
Whitepaper
2025-12-31
US election special: which investment themes win at the polls?
The upcoming US election could be one of the most momentous in recent history. How could the result affect different investment themes? Our thematic team investigate the potential implications for investors.
7
min
Article
2025-10-31
The AI effect: Time to rethink your technology exposure?
Will AI fulfill the market's high expectations? Will it continue to drive market concentration? Head of Multi-Asset Strategy Adam Berger and Global Industry Analyst Brian Barbetta, co-head of our Technology team, discuss the outlook and the asset allocation implications.
7
min
Article
2025-07-31
Factors to consider when allocating to US small-cap stocks
From avoiding "junk" to holding on to "graduates," members of our Fundamental Factor Team share their research insights on the pursuit of alpha in the small-cap space.
18
min
Whitepaper
2026-05-31
What could change the trajectory of value stocks?
Head of Multi-Asset Strategy Adam Berger and Equity Portfolio Manager Nataliya Kofman discuss “resilient” value stocks, disruptive themes, and attractive sector- and country-level opportunities.
7
min
Article
2025-05-31
Small-cap stocks: Watching for mean reversion, technology diffusion, and the next inflection point
Our experts discuss factors that could help small-cap stocks rebound and the search for winners in this inefficient segment of the market.
8
min
Article
2024-12-31
Three ways social considerations can enhance portfolios
Four leading Wellington equity and fixed income experts explore three ways social considerations can enhance portfolios.
5
min
Article
2025-04-30
Why income-seeking investors need to look across asset classes
Income plays an even more crucial role in portfolios than many of us realise, contributing a significant portion of returns for multi-asset portfolios. But with cash rates at around 5%, the world of income has changed. This should prompt investors to take a fresh look across asset classes to see where opportunities lie.
Article
2024-12-31
Learning to love (or live with) a late-cycle environment
Are we actually in a late-cycle environment and, if so, how should allocators respond? Head of Multi-Asset Strategy Adam Berger offers guidance, including on portfolio positioning, big cycle bets, and security selection.
Article
2024-12-31
Closing the return gap: A new set of “stepping stone” ideas
Multi-Asset Strategist Adam Berger offers incremental, flexible investment ideas that can be combined to help asset owners pursue their goals amid declining capital market return expectations.
Whitepaper
2024-08-02
URL References
Related Insights