(Bloomberg) -- The specter of US interest rates at 4% or even higher is bringing into sharper focus the question of when and how investors should really get back into bonds after Treasury markets suffered one of their worst beatings in decades.
Hotter-than-expected inflation means traders are now betting the Federal Reserve will lift its benchmark as high as 4.5% early next year as officials seek to tame price pressures. If that comes to pass, it could help pull large parts of the Treasury curve back up to levels unseen in more than a decade and offer a tempting running yield at a time when riskier assets such as stocks could be coming under additional pressure.
Yet just how to play the market while yields are still rising, how high rates might go before they plateau or fall, and whether bonds will witness increases across the whole curve are all key questions to be resolved as investors try to navigate the landscape.
It has "definitely been a tough year across fixed income," said Mohit Mittal, a fund manager at Pacific Investment Management Co. To avoid more pain, he says it's best to wait until the Fed gets to 4% and then add "shorter maturity exposure in high-quality credit and floating-rate notes."
The central bank's target range is currently 2.25% to 2.50% and swap markets are fully pricing in an increase of at least 75 basis points at the upcoming policy meeting next week, with further hikes beyond that. US yields extended their advance on Wednesday, with the five-year benchmark yield rising as much as 5 basis points to 3.63%, the highest since 2008.
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The market-implied peak in the Fed rate is currently penciled in for around March 2023, with pricing indicating that the central bank may need to re-ease policy after that as higher rates begin to take a toll on growth. A deepening inversion of key curve measures, seen by many as a potential harbinger of recession, helped reinforce that more downbeat view about economic activity.
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Gargi Chaudhuri, who is head of iShares investment strategy for the Americas at BlackRock Inc., said that the recent surge in Treasury yields has created lucrative trading opportunities and that her highest conviction trades through the end of the year are to be in "front-end, high-quality credit."
That's perhaps even more appealing at a time when equities and other more risk-prone assets are starting to look a bit shaky.
Entrenched higher rates are usually a headwind for stocks, as they tend to crimp earnings, lift funding costs, and increase the discount rate for investors, while inflationary pressures are also beginning to cause economic pain on consumers and producers alike. The S&P 500 is on track for its worst year since the depths of the global financial crisis in 2008.
It's that kind of backdrop that has Kerrie Debbs, a certified financial planner at Main Street Financial Solutions, warning her clients they shouldn't expect the lofty equity average returns that persisted before the pandemic. In her view, previously boring choices like certificate of deposits are again worth a look and she's advising them to think about adding more short-term bonds -- and holding them to maturity.
"There's going to be more shock, disappointment and adjustments," said Debbs. "People over past years had become overly anchored in equities given the high returns, but now in this era of higher rates -- for longer -- they are going to be less satisfied."
Adding to the problem side of the higher-for-longer rate ledger is that tighter policy raises prospects of an economic recession. Fed Chair Jerome Powell recently emphasized the "out of balance" nature of the labor market while also acknowledging that the combination of higher rates, slower growth and a softer labor market will "bring some pain" to households and businesses.
There's also a double-whammy of restrictive monetary policy going on as well. The Fed is not only hoisting rates but also unwinding its mammoth balance sheet, with the so-called quantitative tightening process ramping up to full speed this month.
This combination has many investors wary that long-term Treasury rates could have more room to rise even as the curve inverts further, causing great uncertainty about just when people should take the plunge back into bonds.
"The Fed ultimately wants demand destruction," said Subadra Rajappa, head of US rates strategy at Societe Generale SA. "And that's what keeping rates stuck at about 4% is going to accomplish."
(Updates Fed Funds target level in the second paragraph, yields in the fifth paragraph.)
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