The US Federal Reserve (Fed) is one of the most influential drivers of global financial markets, so its monetary policy decisions and actions are critically important. Sometimes, however, the market implications may not be as clear-cut as they might seem.
For example, conventional wisdom tells us that as interest rates rise, existing bonds decline in value. But today’s macro environment is more complex than this simple rule because of the current mix of stubbornly high inflation, weakening economic growth, and a not-so-remote risk of recession. Against this backdrop, I believe higher-quality, long-duration1 fixed income assets may prove resilient even if the Fed continues raising short-term interest rates for many months to come.
The Fed Is Following, Not Leading the Markets
The Fed hiked rates by 75-basis points2 (bps) at its July 27 Federal Open Market Committee (FOMC) meeting, as widely expected. By contrast, the Fed’s 75-bps rate hike in June 2022 overshot expectations for a 50-bps increase. However, I would argue that the central bank’s surprise move in June actually lagged the latest available US inflation data, as it came after an eye-popping headline Consumer Price Index3 (CPI) reading of 9.1% and a spike in consumer inflation expectations.
The takeaway? Neither the market nor the Fed has a crystal ball, but if past is any prologue, it’s quite possible that the Fed will continue to follow the markets (based on incoming data), not lead them. But that’s not necessarily bad news for bondholders with longer-term investment horizons.
What’s the Case for Long-Duration, High-Quality Bonds?
Interestingly, while federal funds rate4 futures contracts are signaling that the market believes the Fed’s terminal rate for 2022 will be around 3.25%, December 2023 futures contracts are currently trading closer to 2.75%, suggesting a belief that the Fed will reverse course and begin cutting rates by mid-2023 (FIGURE 1). Optimistic though it may be, if that forecast is indeed correct, it would certainly make a good case for owning US duration—particularly longer-duration, higher-quality bonds. Of course, the market could be wrong.