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A Q&A with John Flahive, Head of Fixed Income, on what it will take to turn the bond market around and how investors should position themselves in the meantime.

April 27, 2022 


Bonds suffered their worst first quarter performance in 40 years, and the rout has continued, as the market grapples with soaring inflation and how aggressive the Federal Reserve will need to be to bring it down.


May’s Federal Open Market Committee (FOMC) meeting is expected to result in at least a 50-basis point hike to the federal funds rate, taking it to 0.75%. Federal Reserve governors are also likely to announce a Quantitative Tightening plan after the meeting, to reduce its $9 trillion mountain of bonds on its balance sheet.


We sat down with our Head of Fixed Income, John Flahive, to get his opinion on where bond markets are heading, what it will take to turn bonds around, and what investors should do in the meantime.


Year-to-date fixed income performance is the worst in 40 years, with far greater-than-expected declines in bond prices. Why has the performance been so bad?


What has made this market so difficult has been the degree to which yields moved higher across the Treasury curve. We had expected higher interest rates coming into the year, but inflation surprised to the upside and pushed rates higher faster, as markets priced in a much more aggressive round of rate hikes than what was previously expected. We saw short-term rates, especially the 2-year Treasury note, rise more than long-term rates. This reduced the difference between the 2- and 10-year yields and flattened the yield curve.


The back up in yields at the short end of the curve was so dramatic that the usual strategies deployed to buffer against losses in a rate-rising environment didn’t work. 


What strategies are typically used to protect fixed income portfolios during a rate-hiking cycle?


When the Fed starts raising rates, the recommended approach is to move positions into short-duration bonds. You want to reduce your exposure to longer maturities, because the longer the maturity of a bond, the greater its level of interest rate sensitivity.


Of course, the short-dated maturities also tend to rise in yield when the Fed increases the federal funds rate, but typically not by as much as longer-dated maturities like the 10-year Treasury note yield. So, the idea is that reducing exposure to long-dated bonds and positioning in short duration bonds will help to buffer against price losses.


But this time the 2-year Treasury yield rose more than the 10-year, largely because the federal funds rate was anchored at zero and given that the 2-year yield was closer to zero than the 10-year, its increase was greater. So, running a conservative portfolio of shorter maturities has not cushioned against losses as well as it would have done in previous rate hiking cycles.


What needs to happen for investors to get a reprieve from this volatile bond market?


What we really need to see is evidence that inflation is peaking and starting to slow down. And that is our base case, although we recognize that inflation is unlikely to revert to pre-pandemic levels of under 2%.


We’d like to think that the 2- and 10-year yields have already priced in the expected increases in the federal funds rate. So, any sign in the form of economic data that inflation has peaked and is coming down should bring a reprieve.


There’s also another dynamic that should also help to bring down yields later this year, and that’s the fact that Europe is likely to go into recession. If it does then its sovereign bond yields should remain lower than our Treasury yields and bring back foreign demand for our fixed income securities.


When do you think inflation may show signs of easing?


We could easily see the market interpreting that inflation has peaked by the third quarter of this year.


Another factor in play here is the “base effect.” Inflation was higher in the third and fourth quarters of 2021 than it was in the first half of that year, so the difference in 2022 year-over-year inflation growth each month should look a lot lower and less challenging later this year than the first half of 2022. We think inflation in the U.S. will settle near 3.75%-4.25% by the end of the year.


So, the bottom line is that we think it’s still going to be a rough and bumpy ride for bonds between now and the third quarter. But by then we should see evidence of Europe slowing down, and U.S. inflation peaking as well as a slowdown of our economy.


Where do we expect interest rates to go from here?


The prior high on the U.S. 10-year Treasury note was 3.23% in October 2018. We flirted with 3% in mid-April – 150 basis points higher than where we began the year – before closing at 2.8% on April 27. Our view is that we are at the tail end of this rate move higher, at least in the near term.


We believe we will begin to see stability in the 10-year yield if it goes above 3.25%. That’s where we think it might peak. And then the attractiveness of that yield, coupled with European economic concerns driving foreign buying of U.S. fixed income, and possibly greater focus on weakening domestic economic growth, could begin to push the 10-year yield back down. It won’t get down to where it was at the beginning of the year (at 1.51%) but I would not be surprised if we trend back down to 2.25%-2.5% by the end of the year, after peaking at 3.25%.


How are you positioning clients’ fixed income allocations?


Our advice for clients all along has been to underweight fixed income, but don’t eliminate it altogether. I remind clients that we have been cautious in fixed income in general for several years now, with an underweight in a diversified portfolio. Yields have been so low and spreads so tight that we felt that equities and alternative asset classes offered better risk-reward relationships.


We encourage diversification within the fixed income bucket. Clients shouldn’t just own municipal bonds, for example, or only the Barclays Aggregate Index. Their overall fixed income portfolio should include other strategies like high yield, floating rate high yield, even emerging market debt and other opportunistic strategies, all of which have the potential to augment the low return outlook for the core fixed income strategies, as well as provide some ballast.


Within our broader asset allocation, we also advocate diversifying into alternative strategies such as absolute return funds, which can do well in a rising rate environment. There is also the private debt market, which has the potential to provide consistent and lower correlated returns. 


Do you think yields are high enough to attract investors?


Now that we have seen a material adjustment higher in interest rates, the risk-reward characteristics of fixed income is looking more compelling.


We have been very underweight Treasuries within our recommended fixed income portfolio. And while we still maintain that today, we can see a situation in the quarters ahead – particularly if yields go higher – that the concept of There Is No Alternative (TINA) to equities diminishes, and fixed income becomes a more attractive asset class from a risk-reward perspective.


Our belief is that certainly above 3% it starts to look more interesting on 10-year Treasury securities. But the thing to note here, is that you don’t necessarily have to stretch maturities. Given the move higher in yields at the short end of the curve, we think that when it makes sense to add to fixed income exposure, it could be possible to still get attractive returns without having to increase your risk by purchasing longer-dated maturities. Today we have the 2-year yield at 2.6% and the 5-year almost on top of the 10-year.


For the moment we are still taking a cautious stance in our fixed income portfolios. We recommend shorter durations, higher credit quality, and continued diversification of strategies. We actually reduced our risk in corporate credit recently, by going to a neutral exposure in high yield bonds after having had a small overweight.


What is your advice for clients with new money?


Although we are underweight fixed income within a diversified portfolio, a client with new money to invest has a more attractive entry point for fixed income today than we’ve seen in many years.


Because cash returns you nothing, it could make sense to purchase the highest quality fixed income in the 2- to 5-year maturity range. And not just in Treasuries. Investors with new money could also consider taking advantage of the dislocation in the municipal bond market. Normally high-quality municipal bonds are more expensive and carry less yield than Treasuries, as investors will pay up for the tax advantages of the highest quality municipal bonds. But today because retail investors have been selling indiscriminately, high quality municipal bonds now yield the same amount as comparable Treasuries. It’s a dislocation in the market that presents opportunities.


What about tax loss harvesting? Given the rout in the bond market, should investors be thinking about selling bonds and harvesting losses now?


I don’t think it’s necessary to start tax loss harvesting right now. First of all, there is plenty of time this year to tax loss harvest in fixed income – we have until the end of the year. Fixed income is totally different from the equity markets when it comes to harvesting losses. If you don’t move quickly in equities the stock market can move back up again and the opportunity to harvest is lost. You don’t have the same dynamic in fixed income. I don’t see those losses turning around and disappearing in that short a timeframe.


We are recommending clients be a little patient and to not feel compelled to harvest now when liquidity in the bond markets is somewhat challenging.


Where do you think the federal funds rate will be by year-end?


I think it will be around 2.5%-2.75%. I would not be surprised if the Fed front-loads its rate hikes and makes 50 basis point increases in May, June and July. I think the Fed wants to get the federal funds rate closer to 2.5% as soon as possible, so it can avoid making rate hikes around the mid-term elections, when its actions could be misinterpreted as politically motivated. So, I think the Fed may pause during the election and then continue, and under that scenario we could easily see the federal funds rate getting to 2.5%-2.75%.


How will balance sheet reduction by the Fed affect bond yields?


I think balance sheet reductions, or quantitative tightening, is already priced in, and that’s partly why we have seen rates accelerate more aggressively in March and April. Although discussed in the FOMC March meeting minutes, we should get more clarity on balance sheet reductions at the Fed’s May meeting and having that clarity will help to bring calm to the market.


Right now, market consensus is they will announce upwards of $100 billion of reductions in Treasury and mortgage-backed securities on their balance sheet every month. That may be in the form of $100 billion of maturing bonds rolling off, a mixture of roll offs and selling bonds, or even a reinvestment in the market if there are more than $100 billion bonds maturing in any one month. The Fed will want to smooth out the operation, because their balance sheet is huge and reducing it could cause even greater volatility in rates.


They bought $5 trillion of bonds during the pandemic in a bid to keep markets liquid during the crisis, taking its total holdings to $9 trillion. If their quantitative tightening isn’t managed smoothly and causes volatility in rates, it could lead to a policy mistake and throw the economy into a hard landing. While this is not our base case, it will be something to monitor closely.


Do you think we will see a recession this year?


No, I don’t. I’m in the camp that the Fed could still pull off a soft-landing here, meaning that it could tighten monetary policy without tipping the country into recession. We put the probability of a recession in 2023 at 30%.

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