June 10, 2022 | By Hank Cunningham
The Federal Reserve and the Bank of Canada have begun to remove 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 plans to return to the so-called “neutral” level for their key lending rates. This rate is projected to be 2.5%-3% and, barring a major exogenous shock, is likely to occur.
It is reasonable to acknowledge that growth, both domestic and global, will suffer somewhat. Indeed, the IMF has downgraded global economic growth 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 will be reduced or delayed. Meanwhile, the geopolitical landscape has produced wide-spread uncertainty, and even more inflationary pressure.
Real yields are rising rapidly and have moved into positive territory. A combination of further increases in bond yields, plus some easing in inflation will result in real yields turning even more positive. Thus, we expect yields at all maturities to gain further with a 3.25% target for the bellwether 10-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 2%. 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. Most forecasts, including those from the central banks, estimate it will land between 4-5% this year.
It is likely that the Fed will be flexible in its monetary policy, owing to the uncertainty around growth and the geopolitical conflict. Already, the market has discounted several rate hikes and thus is not likely to react in a knee-jerk fashion. Also, the beginning of quantitative easing 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.