Are markets playing catch-up to the Fed?

The big news of the week was, of course, inflation hitting seven percent on a year-over-year basis, according to the Consumer Price Index (CPI), the highest reading since 1982, and a level only seen as putting even more pressure on the Fed to act sooner rather than later.

And so naturally on a data point like that, stocks showed only a muted reaction, and Treasury yields dipped lower, while the dollar continues to weaken. In situations such as this, it’s pretty standard fare to simply chalk it up to markets having already priced in certain data and expectations, and then move on.

But in some ways that’s likely true in this case. Though current inflationary pressures continue unabated, the market’s expectations for inflation in the coming years have actually moderated of late. After peaking at 3.2 percent last year, markets are now looking for inflation to average closer to 2.8 percent over the next five years.

And we can chalk that up to the Fed as policymakers continued to pledge allegiance to lower inflation this week.

Fed up

Eonomists expect that the worst of the inflationary pressures are at least nearing an endpoint. Though inflation will likely continue to run north of seven percent on a year-over-year basis for the next couple of months, RBC Economics sees that pace slowing to 2.8 percent by the end of the year.

Will modest rate hikes be enough to tame inflation?

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Consumer Price Index (y/y)

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Fed funds rate

Dashed lines indicate RBC Economics forecasts as of December 2021

Source – RBC Wealth Management, Bloomberg, RBC Economics

Part of that comes from expectations around more aggressive Fed action this year to tame inflation. Markets are now fully priced for three rate hikes by December, beginning at the Fed’s March policy meeting, with a 50 percent chance the Fed ends up delivering four, based on current market pricing. St. Louis Fed President James Bullard, who votes on policy this year and had forecast three rate hikes at the December meeting, already now sees a case for four, stating that: “If we get a couple of rate-hike moves under our belt during the first part of this year then we’ll be in better shape.”

Admittedly, three rate hikes this year to a policy rate range of 0.75 percent to 1.00 percent looks rather quaint against headline inflation running north of seven percent. But we believe that should be sufficient to at least start reining in the demand side of the demand-supply imbalance that continues to be the primary force behind inflation.

Fed Chair Jerome Powell stated this week that: “In a way, high inflation is a severe threat to the achievement of maximum employment. We think wages moving up is generally a good thing, but if you look back through history, there are times when wages have moved up in a way that has fostered persistent inflation, and that hurts everyone.”

And perhaps that perfectly sums up and explains the market action to start the year: we envision a scenario where the Fed raises rates, but only to a certain point, before pausing as inflation cools, allowing for continued expansion and a full recovery of the labor market, particularly on the labor force participation front. If the Fed can achieve that, it’s a net-positive for markets and the economy, and why markets may now be looking through current inflation numbers.

So goes January, so goes the year?

Given the sharp repricing of Fed rate hike expectations of late, the bond market is now off to one of its worst starts to a year since 2009, with the benchmark Bloomberg U.S. Aggregate Bond Index down 1.5 percent through Jan. 12. And this follows 2021, which was already a rare down year for U.S. bond markets. There have only been four such instances of negative calendar-year returns, and never has the market delivered investors back-to-back declines since the inception of this index.

What’s in store for bond markets after a rare down year in 2021?

Bloomberg U.S. Aggregate Bond Index annual total returns since inception

Source – RBC Wealth Management, Bloomberg

Will that streak come to an end in 2022? It’s certainly possible given that yields remain historically low, but after the jump in yields so far this year, we think further gains will be more moderate, and that bond market returns in 2022 will likely be flat.

For context, bond prices decline as yields rise, so for investors the question becomes whether the price decline is greater than the coupon earned in any given year. So, with all of the concern around rising rates and higher Treasury yields, what might returns actually look like?

The benchmark 10-year Treasury currently yields approximately 1.73 percent. If purchased today, the yield would have to rise to 1.94 percent for the price decline to wipe out the coupon earned for the year; should the yield rise to 2.20 percent by the end of 2022, as RBC Capital Markets currently forecasts, the total return would be negative 2.2 percent. But what if yields were to decline? A slip back to just 1.50 percent would actually generate a solid 3.60 percent return for the year.

The outlook for shorter-dated Treasuries looks slightly better, in our view. Should the 2-year yield rise to 1.35 percent from 0.90 percent currently, as RBC Capital Markets expects, returns would still be positive at 0.44 percent.

But for buy-and-hold investors, all of this may be a moot point, given that returns in any given year are largely inconsequential. But for those reasons, we maintain a slightly negative outlook for Treasuries, and a positive outlook for corporate bonds and preferred shares. However, and importantly, we do expect that over the course of 2022 that bias could shift back in favor of Treasuries should the benchmark 10-year Treasury yield move north of 2.0 percent.

As always, though the return outlook for bonds may be bleak based on current forecasts, they will continue to add ballast and stability for portfolios should volatility persist in 2022.