What’s Next for Fixed Income?

12.29.2021 - Jeffrey S. MacDonald, Head of Fixed Income Strategies

Today, global bond markets face the task of moving beyond COVID-related emergency support, both monetary and fiscal, as the pandemic’s influence over economic activity fades. This transition should represent the major driver of fixed income market dynamics in 2022 as central banks, interest rates and credit markets adjust to the developing outlook for economic growth and inflation.

Central Banks React to Surge in Inflation

We believe the pressure on central banks to adjust monetary policy in response to accelerating inflation will evolve over the course of 2022. Driven by the combined forces of the fading economic impact of COVID and aggressive fiscal stimulus, excess demand has run head-on into supply-related bottlenecks in goods and labor that has driven inflation to multi-year highs.

We expect inflation to run at an elevated level in the first half of 2022 encouraging the Federal Reserve to continue the expected reduction of its quantitative easing (QE) program while other central banks remove emergency COVID-related policy support in their regions. We believe that elevated inflation pressures in areas like housing, food, and energy, could influence the behavior of consumers over the course of the year. The limited flexibility many shoppers have in their budgets for these necessities could reduce demand for more discretionary purchases (i.e., leisure and entertainment). This dynamic, and our expectation that consumer buying habits shift from a focus on goods to services as the reopening continues, should provide some relief to overall inflation in the second half of 2022 and beyond.

We believe that the Fed’s announced QE tapering schedule will provide an adequate window of time to allow these inflation dynamics to play out, reducing the risk of aggressive federal funds rate hikes in 2022. Given this outlook, we think a rate hike in late 2022 is likely as the Fed gradually normalizes monetary policy in pursuit of its’ dual mandate of full employment and price stability.

Interest Rate Expectations Heading into 2022

With economic growth expected to be solid, inflation likely to remain higher than before the pandemic and less Fed support in the system, we believe that interest rates in the US and globally are likely headed higher entering 2022.

Shorter-maturity yields, which tend to take their cues from expectations surrounding central bank policy rates, should continue to respond to forward guidance regarding future rate hikes. Many investors are likely to demand higher rates for shorter-maturity bonds as compensation for these anticipated increases.

Market-based indicators have currently been pricing in several federal funds rate hikes over the course of 2022. We believe a normalization in inflation and employment measures will prove these expectations to be overly aggressive. While we forecast short-term interest rates will move higher as 2022 progresses, actual rate hikes from the Fed could disappoint some market participants and limit the magnitude of the increase.

Longer-maturity yields, which tend to be influenced by the longer-term outlook for economic growth and inflation, should also move higher over the course of the coming year. The reduction of monetary support from the Fed during a time when the US economy is accelerating should lead to longer rates moving higher in 2022 than today. A moderation of inflationary pressures throughout 2022 and 2023 should help the market avoid a spike in longer-term rates. Structural factors like an aging population and productivity-enhancing technologies may reassert themselves as contributors to a modest inflation and interest rate outlook.

Fundamentals and Investor Demand Should Support Credit Sectors in 2022

Creditworthiness across corporate, state and local governments, and consumers should remain strong over the next year based on an ongoing economic recovery and the lagged effect of COVID-related stimulus. Overall, as shown in Chart 1, defaults seem poised to return to historically low levels given our outlook for economic fundamentals and interest rates. Solid demand from investors should continue to allow issuers to bring new deals to the market.

Chart 1: Downward Default Trend Continues

Number of Failing Issuers Has Been Falling

Source: S&P Global Ratings Research and S&P Global Market Intelligence's CreditPro®, as of 9/30/2021

Corporate issuers should maintain strong credit metrics on the heels of solid balance sheets with good liquidity and access to primary new issue markets. State and local government budgets are in the best shape in decades due to conservative COVID-era budgeting, federal support, and revenues that have exceeded budget estimates.

The infrastructure bill signed into law in late 2021 could provide investors with some welcome new issue supply as municipal issuers play a potential role in the financing of these programs. Consumers also carry a measure of credit strength into 2022 as COVID-related emergency relief combined with higher wages and difficulty finding qualified employees has placed consumers on solid footing. Strong real estate and stock markets are also bolstering their net worth.

A Final Thought on Credit Spreads

The additional yield compensation, or “spread”, investors receive for assuming credit risk could increase with a move towards higher overall interest rates in 2022 but should continue to reflect our outlook for solid investor demand and sound credit fundamentals. Occasional bouts of volatility driven by shifts in risk appetite or fundamental outlook are likely in our view as markets transition to a world where COVID represents less of an economic risk. Investors should embrace credit as a means of enhancing yield in portfolios but expectations for price appreciation related to credit risk should remain conservative.

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.


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