- The latest Fed rate hike is unlikely to be the last of this cycle. Furthermore, we believe those betting on Fed cuts in 2023 are likely to be disappointed.
- While down from 2022’s peak, we believe inflation readings are likely to remain elevated this year, preventing the Fed from easing — even if a recession takes hold.
- Investors have the potential to achieve yield targets with less volatility than in years past, underscoring the enhanced role that bonds can play in an investors’ overall portfolio.
Bonds are our top choice if the Fed keeps rates "higher for longer"
Feb 1, 2023 Fixed Income
KEY TAKEAWAYS
“Don’t confuse a Fed pause with a Fed pivot” might not have the same ring as “Don’t fight the Fed,” but it could turn out to be key to investing in 2023.
After the FOMC’s 25 basis point rate hike on Feb. 1, Wall Street’s consensus is for the Fed to raise rates one more time by 25 basis points before reaching close to a peak for this cycle.1 That may prove correct, but we believe those betting on Fed cuts in 2023 — aka “a Fed pivot” — are likely to be disappointed.
If the U.S. economy continues on the Fed's expected path, "it will not be appropriate to cut rates this year,” Fed Chair Jay Powell said in his press conference following the Fed's Feb. 1 meeting.2
Our view is that inflation may have already peaked — and has the potential to decrease further in the coming months — we believe it will remain far from the fed's target of 2% by the end of 2023. We believe elevated inflation readings are likely to prevent the Fed from easing this year, even if a recession takes hold. We think central bank authorities will ultimately raise the fed funds rate to above 5%, and then hold rates in restrictive territory throughout 2023.
"Ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time," the FOMC said in its statement.3
If this proves to be the case, the “risk on” trade that started last fall may prove to be short-lived. Against this backdrop, investors may want to consider taking shelter in investment grade credit, short-dated Treasuries, and stay in value and small-cap stocks, as detailed in our 2023 Year-Ahead Investor Guide. Overall, we continue to see the most opportunity in fixed income.
Video 2:45
KEY TAKEAWAYS FROM THE FED'S FEBRUARY RATE HIKE
iShares investment strategist David Jones discusses the FOMC’s latest action and statement, and what it may mean for investors.
This is David Jones from BlackRock iShares investment strategy.
This afternoon, the Fed raised its benchmark policy rate by a quarter percent point, as broadly expected. To me however, there were a few big takeaways:
First, the FOMC statement was shortened and tidied up and the FOMC acknowledged that inflation had eased somewhat but remains elevated. But importantly, a key sentence in the FOMC’s forward guidance was left unchanged, with that statement still saying that “The Committee anticipates that ongoing increases in the target range will be appropriate”. Many thought the FOMC would water this statement down to reflect the upcoming end of the hiking cycle. Leaving it untouched is a hawkish signal.
Secondly, the markets seemed enamored with the Chair’s repeated use of the word ‘disinflation’, with 10 year rates falling by as much as 13 basis points during the press conference. But listen to what the Chair said: “We will need substantially more evidence to be confident that inflation is on a sustained downward path.” He said “if the economy performs broadly in line with those expectations, it will not be appropriate to cut rates this year”
So what does all this new information mean for investors?
We believe the Fed will keep monetary policy tight until they are certain that inflation will come back down to around 2%. That means potential opportunities for investors in fixed income, but given current valuations, we continue to favor the front end of the curve.
With the dollar weakening, we also like local currency emerging market bonds.
Within equities, we continue to favor defensive, high-quality names, value over growth and relatively inexpensive small caps over large caps.
Secondly, today’s FOMC decision increases the importance of price and jobs data, like this Friday’s nonfarm payroll report. Strong data should favor shorter duration fixed income and value equities because it implies the Fed will have the space it needs to make certain that the fight against inflation is won before it starts to ease interest rates. By contrast, weak data could be seen as the start of a significant slowdown of growth, and that could mean that the Fed may feel compelled to ease sooner than we now expect.
To learn more investing in a higher rate environment, visit the ishares.com insights page.
Bonds are back: While below its 2022 peak of around 4.35%, the 10-year U.S. Treasury note currently sits at 3.46%. Importantly, the 2-year U.S. Treasury bill is even higher — hovering around 4.20% after starting 2022 at 0.80%.4 This means investors have the potential to achieve yield targets with less volatility than in years past, underscoring the enhanced role that bonds can play in an investors’ overall portfolio.
WHY THE FED MAY NOT BE DONE YET
While U.S. Consumer Price Index (CPI) inflation has decelerated from the 9.1% level seen this summer, it’s still well above the Fed’s 2% target. Overall CPI inflation was up 6.5% for the 12 months ending in December, while the core rate — which strips out food and energy — was up 5.7%.
Despite three-consecutive monthly drops in core CPI, we believe the market has become a bit too bullish about inflation returning to target, for the following reasons:
- Services inflation, which comprises 57% of CPI, was up 7% on an annualized basis for the 12 months ending December 2022.5
- Shelter, the largest contributor to services inflation, rose 7.5% in 2022, its strongest annualized rate since the 1980s.5
- Core services, excluding shelter inflation, a data point that has been popularized recently by Fed Chairman Jay Powell, moved up to 0.21% in December vs. 0.15% in November and 0.19% in October.5 (Powell reiterated this message at his press conference on Feb. 1)
- A handful of categories continue to drive inflation lower, including airfare, and new and used vehicles. Unfortunately, these are also often the most volatile categories. The stickier components such as shelter and medical costs continue to be high.
- Longer term, geopolitical tensions, deglobalization, and the impact of onshoring production can drive a secular boost to inflation.
Led by Fed Chair Jay Powell, numerous Fed officials have said they are prepared to leave rates ‘higher for longer’ in an effort to corral inflation — even if the economy continues to slow, potentially into a full-fledged recession.
“Restoring price stability when inflation is high can require measures that are not popular in the short term as we raise interest rates to slow the economy,” Chair Powell said in a speech on Jan. 10.6
ECONOMIC GROWTH IN FOCUS
After investors fixated on inflation in 2022, we believe economic growth and the resilience of the labor market will be the top issues this year, and the growth trajectory is likely to be lumpy rather than smooth.
Notably, the equity rally that started last fall is vulnerable to weaker-than-expected economic data, as well as concerns about the U.S. debt ceiling.
Additionally, monetary policy often works with a lag, which academic studies suggest can last up to four years.7
Because the Fed acted so aggressively last year — hiking rates by 425 basis points in the fastest tightening cycle since the 1980s — we believe further economic damage from 2022’s rate hikes is almost certainly in the cards. Furthermore, “there is considerable uncertainty about how these policy lags will play out,” as Atlanta Fed President Raphael Bostic writes.8
The Federal Reserve may be on the sidelines for much of 2023, but investors will still have to deal with the fallout from last year’s aggressive rate hikes. We may even get a “Fed-induced” recession, to cite another phrase entering the Wall Street lexicon. For more details on investing in a “higher for longer” rate environment amid slowing growth see our 2023 year-ahead investor guide.
