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Fixed-income investors recently experienced a once-in-a-career market correction: a 10% decline in the Bloomberg US Aggregate Bond Index1 (the “Agg”) through the first four months of 2022. For most allocators, this sharp downturn came in tandem with a painful equity market sell-off that has produced a -15% return for the S&P 500 Index2 (as of May 6). It’s been rough sledding for traditional assets so far this year.

The forces behind the fixed-income correction are by now familiar to market participants: rising interest rates triggered by inflation that’s higher and stickier than expected, and a scramble by the US Federal Reserve (Fed) to play catch up—in other words, to rein in inflation before a vicious cycle of surging wages and even higher prices takes hold.

What now? I’m still hesitant to call a “top” for how high 10-year US rates might climb (beyond 3%) because the trajectory of future inflation remains highly uncertain, but I see tentative signs that we may be nearing a plateau. Below are four considerations that are influencing my opinion.


1. How Much Monetary Policy Tightening Is Already Priced-In?

A lot. As FIGURE 1 illustrates, according to the federal funds futures market, many investors now anticipate that the federal funds rate3 will reach 3.2% by the end of 2023, some 200 basis points4 (bps) higher than its current level of 75-100 bps. Fed Chair Jerome Powell wasn’t particularly dogmatic when asked recently to identify a neutral federal funds rate, but he cited a range of 2.0%-3.0%. So, at 3.2%, the market apparently believes the Fed needs to pursue more restrictive monetary policy in order to break inflation’s back.


2. Is the Economy Responding to Higher Interest Rates?

The economy and markets seem to be reacting more to prospective Fed tightening than to actual tightening. Typically, the real economy responds to higher rates with a lag time of six to 12 months. However, as FIGURE 1 shows, a bellwether index of financial conditions (including mortgage rates, asset prices, credit spreads,5 and money supply) has already drifted lower in response to this year’s rate shock (i.e., a 150-bps spike in the 10-year Treasury yield). US manufacturing, home sales, and export data have also dropped lately, albeit from strong levels.



The US Economy Is Already Responding to Higher Interest-Rate Expectations

Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. For illustrative purposes only. The Fed Funds futures contract is for June 2023. The Financial Conditions Index combines yield spreads and indices from US money markets, equity markets, and bond markets into a normalized index. A Z-Score indicates the number of standard deviations by which current financial conditions deviate from pre-crisis (before July 2008) levels. Standard deviation measures the spread of the data about the mean value. Source: Bloomberg, as of 5/5/22.


3. What Will It Take for the Fed to Step Back From Tightening?

Lower inflation and weaker demand. Last week, Chair Powell said it would likely take several months of lower core inflation for the Fed to retreat from its planned 50-bps rate hikes. Powell also mentioned the Federal Open Market Committee will be watching financial conditions closely, along with the labor market. Rising unemployment or any hints that growth is dipping below trend might cause the Fed to pause on rate hikes.

There could also be a path forward in which the market more or less does the Fed’s work for it. It already has to some extent: Without having even tightened policy much (yet), the Fed’s more hawkish rhetoric has itself helped the fixed-income market adapt to the reality of higher bond yields. Plus, a strong US dollar is also disinflationary. To preserve credibility, the Fed may need to meet the market’s already priced-in rate-hike expectations, but tougher financial conditions or falling inflation might give the Fed leeway to pull back from tightening.


4. What Could Go Wrong?

The Fed is in uncharted territory regarding monetary tightening given: 1) the gap between current inflation and the Fed’s target; and 2) the use of tightening to pare back the Fed’s balance sheet, simultaneous with outright rate hikes. The Fed’s estimate that its balance sheet run-off is equivalent to only 0.25% of tightening seems quite low. Moreover, the Fed’s mistaken assumption last year that inflation would prove transitory delayed the beginning of its rate hikes. As a result, US monetary policy remains accommodative, with real (inflation-adjusted) 10-year interest rates still negative as of this writing.

Inflation is the wildcard: The Fed continues to believe higher commodity prices and supply-chain disruptions from the Russia-Ukraine War and China’s COVID-19 lockdowns will ease. If they don’t, the Fed may decide to tighten policy more aggressively than the market currently expects. Under that scenario, Fed overtightening could tip the US economy toward recession, especially if paired with economic and market volatility from ongoing geopolitical turmoil or other sources. On the other hand, if the Fed pulls back and the market doesn’t believe inflation is under control, the Fed’s credibility is at risk.


Investment Implications

Here are three things investors should consider in this challenging environment:

  • Don’t abandon fixed income at these levels — Higher real and nominal bond yields reflect a major market adjustment to a more hawkish Fed. In an environment of decelerating demand and potentially peaking inflation, I think 10-year US Treasuries sporting around a 3% yield represent decent value and could provide some diversification if the economy falters. Additionally, the strong US dollar is deflationary and may help attract more foreign asset flows into US bonds.
  • Diversify fixed-income exposure — Given the uncertain inflation outlook, committing too much capital to long-duration6 US fixed income may be risky. Diversifying across global bond markets and currencies with flexibility to tweak portfolio duration as needed may be a better strategy. High-quality corporate bonds look relatively attractive, with their spreads around the 70th percentile vs. history. Market-neutral alternatives and gold may also help diversify and defend investor portfolios in a risk-off environment.
  • Quality is key for equities — Following this year’s equity market sell-off, and with economic recession now a possibility, many allocators are seeking “places to hide.” We think defensive sectors and dividend payers look likely to outperform the market amid elevated volatility as the Fed removes liquidity in the months ahead. Longer term, many investors are finding opportunities in high-quality companies with solid balance sheets and growing revenues and profits at potentially attractive entry points—including in less-favored sectors such as technology, consumer discretionary, and financials.

The views expressed here are those of Nanette Abuhoff Jacobson and Wellington Management’s Investment Strategy Team. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views, and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

Talk to your financial professional about how you should position your portfolio amid market uncertainty.


1 Bloomberg US Aggregate Bond Index is composed of securities from the Bloomberg Government/Credit Bond Index, Mortgage-Backed Securities Index, Asset-Backed Securities Index, and Commercial Mortgage-Backed Securities Index.

2 S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.

3 The federal funds rate is the target interest rate set by the Federal Open Market Committee. This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

4 A basis point is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security.

5 Spreads are the difference in yields between two fixed-income securities with the same maturity but originating from different investment sectors.

6 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed-income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • US Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets. • Investments in the commodities market and the natural-resource industry may increase the Fund’s liquidity risk, volatility and risk of loss if adverse developments occur. • Diversification does not ensure a profit or protect against a loss in a declining market.

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About The Author
Nanette Abuhoff Jacobson Headshot
Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds

Nanette Abuhoff Jacobson consults with clients on strategic asset allocation issues and works with investment teams throughout Wellington to develop relevant investment solutions across asset classes.

The material on this site is for informational and educational purposes only. The material should not be considered tax or legal advice and is not to be relied on as a forecast. The material is also not a recommendation or advice regarding any particular security, strategy or product. Hartford Funds does not represent that any products or strategies discussed are appropriate for any particular investor so investors should seek their own professional advice before investing. Hartford Funds does not serve as a fiduciary. Content is current as of the publication date or date indicated, and may be superseded by subsequent market and economic conditions.

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