As volatile markets continue to price in an enormous hike by the Federal Reserve, bond investors have begun to embrace safety in their portfolios in response to rising inflation.
Investors have dramatically changed their expectations regarding Wednesday’s rate hike. They now expect a 75-bps rate increase, not 50 bps as the market expected. This increased hawkishness has caused equity markets to tumble and bond yields to surge, temporarily inverting the yield curve, and pushing stocks into bear markets.
Investors support faster Fed action to reduce inflation. However, they are concerned about the possibility of recession.
Nancy Tengler, chief executive and chief investment officer of Laffer Tengler Investments, Scottsdale, Arizona, stated that a surprise 75 basis point increase would make her happy.
“The question is how the economy can avoid a recession. That would depend on the Fed’s actions. If the Fed raises by 50, and says they are willing to consider 75 more, then it is clear that inflation will not be a priority. It is important to load the hikes upfront.
Tengler stated that her firm has been “defensive” in its bond portfolios. This has resulted in a shorter duration and an increase in the underlying quality.
In a rising rate environment, shorter-duration debt is more attractive than longer-dated debt.
Futures on the fed funds, which is the rate on overnight unsecured loans between banks, currently reflect an 87% chance for a 75bps rate increase on Wednesday and 75% probability of another such rise in July. Markets have also included a fed funds rate increase of 4% for the summer of next year.
Bill Ackman is the founder of Pershing Square Capital Management and the chief executive officer. He made the comments via Twitter on Tuesday. Ackman noted that the Fed must deliver on what the market expects.
Already this year, the Fed has raised rates by 75 basis point. The Fed also started to shrink its balance sheets this month in a process known as quantitative tightening. As part of its pandemic policy accommodation, the Fed’s balance sheets grew to almost $9 trillion.
This shift in expectations was made possible by the recent spike in inflation. Data showed that the U.S. consumer prices index (CPI), rose 8.6% in the twelve months to May. This is the largest annual increase in nearly 40 years.
BOND MARKET BETS
Fixed income market players had kept short-term bets in advance of the Fed decision.
However, some have reduced short-maturity trades because they believe there are opportunities in this market due to credit spreads having widened and rates having risen substantially since the start of the year.
“We are still short-term, but to a lesser extent. “We have been improving the quality of portfolios under the premise, that choppier markets should lead to credit spreads widening,” stated R.J. Gallo from Federated Hermes in Pittsburgh.
His portfolios also contain slightly overweight Treasuries. Even though they are short-lived, “we still love the high-quality nature Treasuries for playing defence.”
However, bond investors still see potential in fixed income and, despite Fed’s aggressive tightening of the market, some feel it is time to move away from safety bets.
Jason Brady, chief executive of Thornburg Investment Management, Santa Fe, New Mexico overseeing assets totalling $46 billion, stated that “at this point, being extremely conservative from both credit and duration standpoints is not the best place to be.”
“That’s where it was and we’re moving on.”
Brady stated that his firm is marginally more conservative from a credit spread perspective.
Brady cited U.S. high-yield debt as an example, with the spread to Treasuries increasing to 487 basis points Monday. He noted that investors would get a greater than 7% yield if they invested in U.S. five year Treasuries at 3.5%.
David Petrosinelli is the managing director of broker-dealer InspereX New York. He has been advising investors to be cautious with their bond portfolios since last year’s fourth quarter. However, he still believes that the Fed may slow down the pace of tightening in the future.
A barbell strategy is a combination of short- and long-term bonds. Investors will be able to reinvest short-term securities at a higher rate if rates rise.
Petrosinelli believes that the Fed’s aggressive hikes in this year’s Fed funds will cause a dramatic drop in consumption by 2022.
“This will slow down the Fed’s fourth quarter rate hikes. While they will need to raise rates again, the pace of this increase is expected to decrease.