No, we do not recommend that investors go long duration in fixed income portfolios. The uncertain inflation outlook and potential for more aggressive policy tightening suggest yields could rise further. That said, we believe investors that are short duration in their fixed income portfolios should increase duration to match their benchmark, given the improved risk/reward trade-off of longer-duration Treasuries.
US Treasury bonds have sold off to start the year, with the Bloomberg US Treasury Bond Index declining 5.6% in first quarter 2022, its worst quarterly return since its inception in 1973. As it stands, the yield on ten-year US Treasuries is up roughly 150 basis points (bps) this year to 2.9% as of last week. The speed and magnitude of this year’s sell-off has been extraordinary from a historical context. On a rolling three-month basis, there have only been seven previous episodes since 1990 when ten-year yields increased by more than 100 bps in such short order, with the most recent occurring during the 2013 Taper Tantrum.
Treasury yields have increased sharply this year in response to the dramatic change in interest rate expectations. At the start of this year, the Fed funds futures curve implied that the Federal Reserve would hike the Fed funds target rate 75 bps in 2022. Now, futures suggest the Fed may hike a total of 275 bps in 2022 to a target range of 275 bps–300 bps, slightly above the Fed’s neutral estimate of 2.4%. The Fed plans to move quickly to tighten monetary policy to combat elevated inflation. US headline CPI increased 8.5% in March, its fastest rate since December 1981. There are some signs inflationary pressures may be peaking. For instance, core goods prices fell 0.4% month-over-month in March, their weakest reading since the onset of the pandemic. However, Russia’s invasion of Ukraine and lockdowns in China have raised the risk that elevated inflation will persist for longer, and the Fed may need to tighten by much more than expected to bring it under control.
Given uncertainty about the inflation outlook and Fed policy, we do not recommend investors go long duration in fixed income portfolios at this time as we believe the upside risk to yields remains elevated. In fact, with ten-year nominal Treasuries currently yielding 2.9%, it seems reasonable to expect them to eventually break through their peak at the end of the previous cycle of 3.2%, given real yields remain depressed. The US TIPS ten-year yield briefly turned positive last week for the first time since early 2020, but it is still well below its pre–COVID-19 peak of 1.2%. The Fed plans to tighten monetary policy much more aggressively than it did during the previous cycle to combat inflation. In prior cycles, yields tended to keep increasing when the Fed tightened policy, with the ten-year nominal yield typically peaking near or above the peak Fed funds target rate, which is currently near 3.5%, according to futures markets. And this would likely increase further in a scenario in which inflation persists for longer.
At the same time, the Fed tightening too much too quickly potentially increases the risk of a hard landing—a scenario that would likely cause Treasuries to rally sharply, given the negative impact to growth. In our view, the risk of recession in the United States over the next year or so seems limited. That said, some indicators suggest the risk of a recession is rising, and the recent sell-off did bring the risk/reward trade-off of holding longer-duration Treasuries more into balance. For example, assume ten-year yields increased another 60 bps to 3.5%, then ten-year Treasuries would return -1.4%. However, if ten-year yields fell 60 bps, essentially reversing the rise in yields so far this month, then ten-year Treasuries would return 8%. In addition, longer-duration Treasuries are finally beginning to look more attractive from a valuation perspective at current yields. According to our bond model, which is based on trailing ten-year nominal GDP growth and forward policy expectations, the ten-year Treasury yield is trading in line with its fair value.
While yields could go higher, particularly if future inflation data exceed expectations, yields have increased enough to warrant a neutral duration position.