Higher yield rates will bring turmoil in markets
After a year of calling inflation "transitory," the Federal Reserve is finally catching up to normalise its monetary policy. With the unemployment rate dropping fast below 4 percent at the end of last year, it's fair to expect pre-pandemic unemployment conditions to be reached relatively soon. This leaves the central bank free to focus on more pressing issues such as inflation. Although price pressures are set to moderate this year, there are signs that they could remain sustained and above the Fed’s target for a long time. Wage growth continues to rise, supply-chain bottlenecks are likely to remain a problem until 2023, and productivity growth remains depressed. As political pressures to fight inflation mount, the Federal Reserve has been pushed to change its accommodative posture and turn more aggressive than the market originally forecasted; this has provoked the US yield curve to flatten considerably.
A flat yield curve is a problem for a central bank looking to hike interest rates because it exposes the economy to the risk on an inverted yield curve, which historically has been seen as a strong indication of an upcoming recession. Real yields had never been this low and deeply negative before the Fed began a hiking cycle. It may be why, in an attempt to steepen the yield curve, Fed members discussed reducing the Fed's balance sheet.
Everything points to the beginning of a bond bear market, which will see the US yield curve shifting higher while bear flattening. The short part of the yield curve will continue to rise amid more aggressive monetary policies. The long part of the yield curve will also shift higher, but at a slower pace, as yields remain compressed by a slowdown in growth expectations and an increasing demand for US Treasuries. We expect 10-year yields to find strong resistance at 2 percent and end the year not far from this figure.
Real yields will ultimately drive the rise in nominal yields. Indeed, as the Federal Reserve becomes more aggressive, breakeven rates decelerate. At the same time, nominal yields soar, accelerating the rise in TIPS yields. It is terrible news for risky assets, which currently continue to be underpinned by negative real yields but are facing the prospect of more stringent financing conditions.
Such a move will have profound consequences for the corporate bond space. Assets with high duration, such as investment-grade bonds, will need to be repriced. At the same time, junk bond spreads will widen amid more restrictive financing conditions as real yields approach 0 percent. That’s why we remain conservative and look at the corporate bond space opportunistically. The only way to successfully navigate these markets is to cherry-pick credits while taking the shortest possible duration and hold these bonds until maturity to avoid a capital loss. Although cash is toxic amid a high inflationary environment, it is wise to keep liquid to enter positions as new opportunities arise in the future.