Yields on US Treasuries have started the year off sharply as investors face the possibility that the US Federal Reserve will not just embark on an accelerated cycle of rate hikes, but also advance the timetable for begin to reduce the size of its balance sheet.
As the Fed and other central banks prepare to tighten monetary policy to combat lingering signs of inflation, just as the spread of the omicron variant of COVID-19 produces further economic disruption, we expect that financial markets are experiencing heightened volatility in the first quarter of 2022.
Given the progress of this economic cycle and the market’s heightened sensitivity to incoming data as the Fed prepares to withdraw its stimulus, PIMCO advocates an agile approach and prefers investments at the upper end of the spectrum. liquidity. We also favor underweight duration or market exposure to US interest rates.
Central banks take center stage
US 10-year yields hit their highest level in two years to start 2022, climbing to around 1.79% from 1.51% at the end of 2021. The yield curve, which represents the difference between the Short-term and long-term bond yields flattened as investors raised expectations for the Fed and other central banks to raise near-term policy rates.
The moves came as the Fed released the minutes of its December policy meeting last week which further underscored the central bank’s recent hawkish turn in the face of economic data showing continued strength in inflation and inflation. wage growth.
At that meeting, officials laid out their forecast for rate hikes, with the median projection showing three increases in 2022, three more in 2023 and two in 2024. The Fed also doubled the pace of tapering its purchase program of assets, which is ongoing. track to end in mid-March.
Other major central banks have also recently changed course. In December, the Bank of England unexpectedly raised its key rate to 0.25% from 0.10% to tackle lingering inflationary risks, while the European Central Bank announced it would cut its own asset purchase program.
Minutes showed that the Fed also discussed a timeline to potentially begin its balance sheet runoff. That’s when the Fed will no longer reinvest proceeds from maturing Treasuries and mortgage-backed securities it purchased under its quantitative easing (QE) program. The minutes say officials are focused on inflationary risks and see the labor market nearing levels the Fed considers peak employment.
Outlook calls for volatility
The latest monthly US jobs data, released last week, provided further evidence of the forces likely to accelerate policy tightening. The report showed strong hourly earnings and an unemployment rate that fell to just 3.9%, numbers that appear to support the likelihood of the Fed’s first rate hike in March. In this case, a balance sheet reduction announcement could come as early as the middle of the year, in our view.
Data this week showed the consumer price index rose 7% year-on-year in December, the fastest annual pace in nearly 40 years. This was broadly in line with economists’ forecasts and market expectations. 10-year US Treasury yields fell slightly after the report.
The prospect of higher rates and a rollback of central bank bond-buying programs — known as quantitative tightening, or QT — is rippling through financial markets. The Treasury Inflation-Protected Securities (TIPS) break-even rate, which measures the difference between nominal and inflation-adjusted returns, fell late last week amid concerns about the potential QT and the increase in TIPS issuance planned for 2022.
Despite the possibility of increased volatility, we believe that 2022 can provide an attractive opportunity set for investors positioned to take advantage of macro and relative value opportunities when they arise. We also expect active duration management to become a more important driver of investment returns than in the past.
All investments contain risks and may lose value. Sovereign securities are usually backed by the issuing government. Obligations of US government agencies and authorities are backed to varying degrees, but generally are not backed by the full confidence of the US government. Portfolios that invest in such securities are not guaranteed and their value will fluctuate. Inflation-linked bonds (ILB) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs lose value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the US government.
US Federal Reserve (Fed)
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