April 21, 2022 | By Hank Cunningham
The Federal Reserve and the Bank of Canada have begun removing monetary accommodation and there is more tightening to come. To date, there has been little impact on economic data nor has the geopolitical conflict fed into the mix. Indeed, the Fed has maintained a positive economic outlook and is forecasting the inflation rate to average out at 4.3% for 2022. Many central banks, including the Bank of Canada, the Bank of England and the ECB, have joined the Fed in tightening.
The Fed and the Bank of Canada have discussed their plan to return to the so-called “neutral” level for their key lending rates. This rate is projected to be 2.5% and is likely to occur, barring a major exogenous shock.
It is reasonable, however, to acknowledge that growth, both domestic and global, will suffer somewhat. Indeed, the IMF has downgraded global economic growth prospects for this year and next to 3.6% versus previous estimates of 4.4% and 3.8%, respectively.
Consumer sentiment has ebbed but retail sales have held up. A major concern is whether capital spending is reduced or delayed. At the same time, the geopolitical landscape has produced widespread uncertainty, and even more inflationary pressure.
Real yields are rising rapidly but still remain negative. A combination of further increases in bond yields, plus some easing in inflation will result in real yields turning positive.
Thus, we expect yields at all maturities to gain further with a 3.25% target for the bellwether ten-year U.S. note. Corporate bond yields will move up in at least a similar fashion and possibly widen further from Treasury yields. Corporate financial health remains solid.
Wage pressures are escalating and may prevent the inflation rate from falling back to the 2% level. Commodity prices have soared of late too. Long-term deflationary pressures, such as demographics and technology, will re-emerge eventually and help ease inflation. Overall, inflation will be slow to subside, with most forecasts, including those from central banks, estimating it to land between 4-5% this year.
It is likely that the Fed will be flexible in its monetary policy, owing to the uncertainty surrounding growth and the geopolitical conflict. Already, the market has discounted several rate hikes and thus markets are not likely to react in a knee-jerk fashion. Also, the beginning of QT by the Fed and other central banks will impact market yields negatively.
Given this outlook, returns for fixed income investors will continue to be disappointing.