The Federal Reserve refrained from raising rates in yesterday’s policy announcement, but it did signal both an end to asset purchases and a rate increase for March. No news there.
However, Fed Chair Powell did not deny the possibility of hikes to interest rates at each policy meeting this year. If it happens, that would be roughly double the increase the market had been expecting.
Needless to say, the impact so far has been to further weaken risk assets and continue the growth-to-value rotation. There are also increasing signs the general market is worried about the possible extent of action, with major equity indices moving into negative territory year-to-date.
Bond yields, especially US ones, have risen. Short-dated yields are back around 18-month highs. Having been bearish for most of that period, we are starting to believe we will see positive returns from the short end of the US market over the coming year and we are likely to shift our portfolios more into this part of the market.
US 5-year Treasury yields have reached about 1.7%. We would not call them cheap at this level, but while yields could move higher still, we think any capital loss is unlikely to outweigh the income on these bonds. Furthermore, the market has now priced in five 0.25% rate hikes this year, so the risk of an upward adjustment in rate expectations is much less than it was.
While we’re moving back into US short-dated bonds, we still think long-dated bonds are too expensive. The Fed is expected to raise rates to 2.5% by the end of 2023, so to have a 30-year yield well below this level is surprising. The market clearly thinks that short-term rate hikes may need to be unwound in the future if they threaten the economic recovery. We disagree. We think the economy can withstand higher rates and we should prepare for ‘higher for longer’.
While we think 30-year bonds are expensive, we think it could take longer for the market to come round to our thinking. We wouldn’t be shocked if yield curves flattened more, or even inverted, with the 30-year yield moving below the 5-year yield. The US 5-year currently yields around 40 basis points more than the 30-year; about half the long-term average. If yields do flatten further, or invert, we may look to implement a ‘curve steepener’: shorting longer maturity bonds while staying long of 5-year bonds.
Moving away from the US, there are close to 4 hikes expected in the UK. We continue to avoid UK gilts and don’t have many sterling corporate bonds. The UK market in isolation looks highly vulnerable to aggressive rate hikes, especially in the wake of the US move. We continue to recommend getting out of gilts despite their appalling performance in recent times.
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