NEW YORK – The Federal Reserve’s well-telegraphed plan to hike interest rates by half a percentage point on Wednesday and start reducing its balance sheet has failed to ease inflation and growth worries, prompting bond investors to seek safety by adjusting the duration of their portfolios.
Safety trades can mean going short or long duration depending on the perceived risk, asset managers said.
With the US central bank fighting to stem soaring inflation, fed funds futures, which track short-term rate expectations, have priced in at least three 50 basis-point increases this year, with more than 250 basis points in cumulative hikes.
By the end of 2022, the market has priced in a fed funds rate of 2.86 percent, compared with the current 0.33 percent.
The Fed is expected to yank two legs out from under the punch bowl, by raising rates again and allowing its nearly $9 trillion balance sheet to shrink by as much as $95 billion per month starting in June, a two-fisted approach that has never been attempted with such intensity. (Full Story) (Full Story)
Ahead of the Fed meeting, many bond investors have maintained holdings of short-duration fixed-income securities, typically anywhere between one- to three-year maturities, as they hedge against an aggressive pace of Fed tightening. Shorter-duration bonds, in general, outperform longer-dated ones in a rising rate environment.
Some investors such as Insight Investment have also opted to go neutral when it comes to duration risk, after being underweight this benchmark for some time.
“There’s still a fair amount of uncertainty,” said Jason Celente, senior portfolio manager at Insight Investment.
“Will inflation come down? Will the Fed err on the side of running inflation a little bit hotter than what it has been in the past? We think that’s probably going to take a little bit of time to play out.”
As inflation expectations escalated and the Fed’s reaction to it drastically shifted over the past several months, US Treasuries in 2022 sold off sharply. The ICE BofAUS Treasury Index plummeted 8.2 percent this year, on track for its worst performance since at least 1997.
The shorter-duration ICE BofA 1-3 year US Treasury Index performed a little better though, with losses of just 2.7 percent so far in 2022 and 0.3 percent for the month of April.
“The simplest and lowest-risk solution is simply to reduce or eliminate duration risk,” said John Lynch, chief investment officer at Comerica Wealth Management.
He cited money market fund yields, which have risen from zero to about 0.25 percent and should continue to rise as the Fed embarks on its tightening program.
Lynch also recommends ultra-short bond funds, with durations of less than one year, delivering better than expected returns than the longer-duration options, with yields rising in the 1.40 percent range.
Some are also hedging against the possibility of US recession. That view gained traction last week with the contraction in the US gross domestic product for the first quarter.
GDP fell at a 1.4 percent annualized rate in the first three months of the year, data on Thursday showed.
“The Fed is going to struggle to reach the number of hikes that the market has priced in,” said Peter Cramer, head of insurance portfolio management at SLC Management. – Reuters
