Fixed Income

Is it time to reconsider short duration bonds?

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Key takeaways
Rate hikes are priced in
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The short end of the US yield curve has priced in the full extent of likely Fed action this year, and we do not anticipate further near-term increases in short-term yields.

Reconsidering short duration bonds
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After a period of negative total returns, we believe returns at the short end should look more positive going forward.

With inflation above its target and the labor market very tight, The Federal Reserve has laid out a plan to get to a “neutral” federal funds rate as soon as “practicably possible.” We believe this means the Fed would like to get short-term interest rates close to 2.5% before the end of this year. With short-term interest rates just above 0.25% now, this would be a very large increase.

The market has been moving to price in these aggressive tightening expectations — it’s currently pricing in a rate hike at every Federal Open Market Committee (FOMC) meeting this year, with a number of these rate hikes expected to be 50 basis points. This means the short end of the US yield curve now prices in the full extent of likely Fed action this year, and we do not anticipate further near-term increases in short-term yields. Many investors have sought protection from this repricing by owning floating rate notes. Is now the time to reconsider short duration bonds at these high yields? After a period of negative total returns, we believe returns at the short end should look more positive going forward.

Fed balance sheet

Stability at the short end of the yield curve should also help limit yield increases further out on the curve, but we would anticipate some modest steepening going forward. The Fed will likely begin reducing the size of its balance sheet after the May FOMC meeting. The Fed’s balance sheet is currently about $9 trillion in size,1 but we estimate it should be closer to $6 trillion in a normal environment. This leaves $3 trillion of assets to potentially transfer from the central bank to the private sector. The Fed’s stated plans are to allow its balance sheet to decrease by not reinvesting principal and interest payments, but it is possible it may also execute some outright sales, which would be a hawkish surprise. We expect Fed balance sheet reduction, or quantitative tightening (QT), to keep some upward pressure on longer maturity Treasury bonds. 

We estimate $3 trillion in assets could be transferred from the Fed to the private sector over time

Sources: US Federal Reserve as of April 13, 2022; Invesco estimates. For illustrative purposes only. Estimates may or may not come to pass.

Longer maturity bonds

The upside to longer maturity Treasury yields is likely to be tempered by the fact that we have probably seen the near-term peak in inflation, and that year-over-year core inflation (excluding food and energy) is likely to decline in the coming months.

Core inflation increased at a very strong pace in the second quarter of last year and is unlikely to increase at such a pace in 2022. This means that the next few months will likely see an easing of the inflation angst in the market. While inflation will likely still remain well above the Fed’s targets throughout 2022, concerns about ever increasing inflation are likely to ease.

We believe the pace of inflation increases going forward won’t match 2Q21

Source: Macrobond, April 12, 2022. The Consumer Price Index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices.

10-year Treasury yields may have some more upside, but given easing inflation concerns, we would expect 10-year yields to not rise much above 3% in the near term. This is equivalent to a 0% 10-year real yield (nominal yield less inflation expectation), as measured by the US Treasury Inflation-Protected Securities (TIPS) market. A 0% 10-year real yield is the yield that prevailed prior to the pandemic shock.

Real and nominal Treasury yields are close to pre-pandemic levels

Source: Macrobond, April 12, 2022. Past performance is not a guarantee of future results.

Bottom line

We believe the big bear move in US Treasuries is behind us — the short end of the US yield curve is priced for likely Fed action and should provide some stability going forward. The longer end of the US yield curve could see continued moves higher, as the Fed engages in QT, but we would not anticipate 10-year Treasuries rising much above 3% in the near term.

Footnotes

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    Source: US Federal Reserve as of April 13, 2022