The Fed’s Battle to Tame Inflation May Elevate Bond Market Volatility

The Federal Reserve (Fed) and other central banks have embarked on a difficult task — taming raging inflation without triggering a recession. We believe the odds are stacked against policymakers achieving both goals. Tempering inflation remains their priority, and the global economy will likely suffer in the process.

Bond Market Outlook

A series of increasingly aggressive interest rate hikes have been no match for U.S. inflation, which recently climbed to a 41-year high. In Europe, where inflation stands at a record high, the European Central Bank (ECB) on July 21 finally increased rates for the first time since 2011. U.K. inflation hit a 40-year high in June, despite its central bank having hiked rates five times between December and June.

Recession Risk Is Rising

The combination of elevated inflation and rising rates has led to a dramatic slowdown in U.S. economic growth. In the eurozone and the U.K., growth outlooks are plummeting as the region contends with an escalating energy crisis. We believe recession risk is much greater in Europe.

Looking ahead, weak growth — hindered partly by record-low U.S. consumer confidence — and high inflation means recession risk is mounting. We expect the U.S. to enter a period of stagflation that will morph into a recession by 2023. The magnitude of the downturn will depend on the amount of central bank tightening necessary to cool inflation.

An Aggressive Fed Is a Necessity

The labor market, a primary driver of inflation, is a crucial indicator for the Fed. The unemployment rate has remained unusually low, particularly for a slowing-growth economy. This dynamic suggests the Fed may need to be more aggressive if it expects to alleviate excess demand in the economic system.

Inflation, Volatility May Remain Higher for Longer

Even if inflation is nearing a peak, we don’t expect a swift reversal. Various structural and cyclical pricing pressures continue to alter the global economy. Inflation will likely remain well above the Fed’s comfort zone for an extended period.

Given this mix of economic influences, we expect market volatility to remain heightened in the months ahead. Lingering geopolitical tensions will also further aggravate the investment backdrop. Accordingly, we remain cautious in our fixed-income portfolio positioning and sector strategies.

Sector Views: Curbing Risk Exposure

Still-high inflation, hawkish central bank policy and ongoing volatility will continue to challenge fixed-income investors. Here’s how our sector teams are responding:

U.S. Government

Given today’s high-inflation backdrop, we still believe Treasury inflation-protected securities (TIPS) offer value. Although the Fed is taking steps to slow inflation, we believe inflation will remain well above policymakers’ 2% target. Prices likely will remain under pressure as marketplace demand shifts from goods to services.

In addition, the uncertain geopolitical environment may continue to drive commodity prices higher. These factors highlight the potential benefits of securities that protect against inflation.

U.S. Securitized

Among credit-sensitive securities, we generally favor short-maturity, senior securities offering the potential for significant yield advantages and minimal pricing volatility. Attractive valuations among agency mortgage-backed securities (MBS) led us to aggressively add exposure to these securities in the second quarter. Overall, we remain optimistic regarding the sector’s performance prospects in the near and intermediate terms.

U.S. Corporate

Heightened volatility and economic uncertainty have prompted us to adopt a more defensive posture. We are reducing exposure to lower-rated finance and industrial companies. We expect inflationary pressures and slower economic growth to affect corporate profits and weigh on credit fundamentals. This backdrop should push spreads wider, which we believe ultimately will create attractive buying opportunities in the corporate sector.

Municipal

We expect the volatility of municipal bond rates to subside, which should aid the asset class’s performance potential. Accordingly, we are positioning portfolios with a more neutral duration stance relative to peers. We continue to focus on higher-quality sectors and issuers, as we expect slower economic growth to modestly pressure credit spreads. However, we also expect credit fundamentals to remain durable. Unspent federal recovery funds, strong tax collections and solid reserve fund balances should support fundamentals as the economy slows.

Non-U.S. Developed Markets

We remain modestly overweight in U.K. government securities. In our view, the market is pricing aggressive tightening from the Bank of England, significantly above our estimation for the neutral rate.

In Europe, we are maintaining a neutral duration, with an overweight in semi-core countries, including Finland and Ireland. We expect the ECB to gradually increase its policy rate to curb inflation expectations. Meanwhile, the region’s growth outlook remains weak, and we believe recession probability is high. The Russia/Ukraine conflict continues to rattle energy markets, and energy prices account for a large portion of Europe’s high inflation rates.

Our portfolios generally favor the U.S. dollar due to our expectations for U.S. inflation and interest rates to remain higher than in other developed nations. Demand for perceived safe-haven investments also may benefit the dollar ahead of a likely recession.

Emerging Markets

We are generally maintaining a defensive posture, including relatively low exposure to market volatility, in external and local debt. Recently, we further reduced local-market risk by cutting exposure to commodity-exporting countries. Overall, we prefer to hold securities in countries with steep yield curves. Among external debt, we prefer sovereigns and corporate securities with commodity exposure.

Money Markets

In our money market portfolios, we favor overweights to floating-rate instruments, given expectations for elevated inflation and additional Fed rate hikes. We are starting to extend durations to capture yield advantages ahead of potential Fed rate cuts in late 2023.