LPL RESEARCH PRESENTS outlook 2022- How Much Higher Can Treasury Yields Go?
Coming into 2021, we expected Treasury yields to move higher.
And they did. Higher inflation expectations, less involvement in the bond market by the Fed, and a record amount of Treasury issuance were all reasons we thought interest rates could end 2021 between 1.50% and 1.75%. For 2022, near-term inflation expectations above historical trends and improving growth expectations once the Delta variant recedes are reasons why we believe interest rates could move moderately higher from current levels. In 2022, we expect the 10-year Treasury yield to end the year between 1.75% and 2.00%. However, an aging global demographic that needs income, higher global debt levels, and an ongoing bull market in equities (which potentially means more frequent rebalancing into fixed income) may keep interest rates from going much higher in 2022.While we don’t expect interest rates to move much higher next year, because starting yields for core fixed income are still low by historical standards, returns are likely to be flat to the low-single digits in 2022. Not a great year but we should see an improvement over the negative fixed income returns we have seen in 2021.
The role of fixed income
With long-term interest rates close to what we think will be cycle highs, it’s important to revisit the case for fixed income within a broader asset allocation. Core bonds have historically provided capital preservation, diversification, and liquidity to portfolios, which we think are important portfolio construction objectives and help clients remain committed to their investment goals. With the economy likely transitioning to mid-cycle, the need for high-quality bonds increases in our view. Moreover, the need to offset potential equity market volatility remains an important role for core fixed income.
Bonds, particularly core bonds, have been less volatile than stocks and have historically provided ballast to portfolios during equity market drawdowns, which as we know, are normal occurrences from time to time. The maximum drawdown for bonds, in any given month, has been dramatically less severe than stocks [Fig.7]. While the worst drawdown in a month for equities was -28%, the worst bonds have done during a month was down 6%, and those losses were quickly reversed. So, when combined with equities, bonds help reduce total portfolio volatility, which makes for a smoother investment experience for clients.
What’s next for credit?
As interest rates increased during 2021, investment-grade corporate debt was negatively impacted as the sector, perhaps surprisingly, is among the most interest rate sensitive fixed income asset classes. U.S. high-yield investors, however, were rewarded for owning riskier debt. During the year, credit risk was rewarded as opposed to interest rate risk. As the economy transitions into mid-cycle, credit investors need to be more cognizant of downside risks. While the economy should still be conducive to credit risk and corporate balance sheets generally remain in good shape, credit spreads are among the lowest they’ve been in years, which means compensation for the added risk of corporates is low.
Both investment-grade corporate credit spreads and high-yield credit spreads are in the bottom 5% compared to history, which means valuations have been cheaper 95% of the time over the past 20 years [Fig.8]. Corporate credit markets, both investment grade and high yield, are currently priced near perfection, so any unforeseen event— either related to the economy or at the corporate level—could negatively impact credit markets. We remain neutral on investment-grade corporate credit, but we think equities continue to offer better upside return potential than high-yield bonds, where we remain underweight. For income-oriented investors willing to take on more risk, we think bank loans still make sense, where appropriate.
Will Fed tapering lead to a faster increase in interest rates?
The Fed takes a step back
Since March 2020, the Fed has supported the economy and financial markets by purchasing $120 billion in Treasury and mortgage securities each month, and by keeping short-term interest rates near zero. As the economy continues to recover, however, the need for continued monetary support wanes. As such, the Fed is expected to fully end its bond buying programs by mid-2022 with interest rate hikes, in our view, likely starting in early 2023. The big wildcard remains how “sticky” inflation will be throughout 2022. If inflation continues to run hotter than the Fed is comfortable with, we could see a rate hike take place towards the end of 2022. Right now, Fed officials are pretty evenly split on if rate hikes should begin in 2022 or 2023.
A still open question is what the make-up of the Federal Open Market Committee (FOMC) will look like in 2022. Due to resignations and term limits, there are a number of seats yet to be filled. We do think that once those open seats are filled, the Committee will lean a bit more dovish, which should mean continued monetary support for longer. Additionally, given the open seats, we expect changes that result in stricter ethics rules for members of the Federal Reserve System and potentially increased banking supervision from a newly appointed vice chair of supervisory. We do not expect these changes to have an immediate impact, but they may result in longer-term changes to supervision over the banking system and monetary policy, including more of a focus on financial inequality and climate change.
This research material was prepared by LPL Financial LLC. Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC). Insurance products are offered through LPL or its licensed affiliates. To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.
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