In May’s FOMC meeting the Fed delivered its most aggressive move in 22 years. But policymakers are firmly playing catch-up as they look to combat runaway inflation.
Central bank rhetoric and actions remain the key driver for markets as they look to balance the tightening path without creating an accidental recession.
Against this backdrop, Steve Ellis, Global CIO Fixed Income, Fidelity International, provides his outlook for the bond market and why the team believes long duration assets can play an important role in investors’ portfolios.
“In hindsight, the Fed committed a policy mistake last year by letting inflation run out of control, and as a result, it could be walking a narrow road for some time.
“So far markets have been optimistic and have given the Fed the benefit of the doubt, pricing in a soft landing with rate hikes having only a limited impact on growth.
“Historically, however, the Fed has rarely managed to engineer a soft landing. Rather, the risk is that financial conditions tighten aggressively to the point that the market narrative shifts from inflation to recession.
“This scenario is not currently discounted in asset prices. Indeed, our own in-house aggregate recession model suggests just under 15% probability within the next two quarters. Should the tide turn, risky assets would have to reprice quite significantly from here.
“Credit spreads would not be immune, and we are defensively positioned. On a relative basis, however, we do see value, and a reasonable amount of risk premium, priced into areas such as investment grade assets, with all-in yields that look quite attractive now.
“On the other hand, we are treading carefully in the higher beta segments of the market such as high yield and emerging market debt. Diversification remains essential, and we retain a constructive view on duration after the recent rise in government bond yields. With 10y US yields now above 3%, and a further 250bp of Fed rate hikes priced over the next 12 months, markets have already priced in significantly tighter monetary policy ahead.
“Taking this into account, we believe long duration assets can play an important role in investors’ portfolios, both as a source of income and as a diversifier to cushion returns against the volatility that we expect in the months ahead.”
Further medium-term views from Fidelity International’s fixed income team can be read in our Fidelity Fixed Income Monthly. For the full report, please click here.
