As inflation soared in 2022, the US Federal Reserve (Fed) tightened monetary policy at an unprecedented speed – raising the fed funds rate by 450 basis points in just under a year.
The fed funds rate is the interest rate that banks charge to borrow or lend to each other overnight. It exerts a strong influence on other short-term interest rates, including US Treasury yields – in other words, when the Fed hikes rates, the interest on short-term US government debt also rises. Notably, US 3-month Treasury bills yielded about 4.7% as of mid-February, up from roughly 0.2% at the start of 2022.
In a market where most asset classes saw negative returns, the attractive yields on short-duration bonds provided investors returns on their cash with little to no risk.
As we’ve crossed into 2023, US inflation has continued to gradually cool and growth remains negative. But signs of stickier inflation, other strong economic data, and more hawkish signals from Fed officials have led investors to reassess the path of interest rates.
In particular, that’s resulted in markets shifting up their expectations for the Fed’s “terminal rate” – or the peak rate of its hiking cycle – and has lifted bond yields across the board.
Since interest rates are a key driver behind bond yields, it’s important to understand where rates could be headed. Let’s dive in deeper, with a focus on the impact on the “front end of the yield curve”, a.k.a. short-dated bonds.
Recent US economic data have shown that inflation may be stickier than investors previously expected. And a still-strong labor market could further add to inflationary pressure in the US.
Fed Chair Jerome Powell has stated that interest rates may reach a higher peak than investors expect if the jobs market doesn’t show signs of cooling. Other Fed officials have also emphasized the need for further rate hikes to rein in inflation.
Markets have adjusted their expectations as a result, and now see the Fed hiking its benchmark rate two to three more times this year from its current range of 4.5% to 4.75%.
That’s broadly in line with the central bank’s latest projections in December. But there is still a disconnect between where investors and the Fed see rates by year-end. While the Fed has consistently signaled that rate cuts are unlikely this year, markets still see some scope for easing toward the end of 2023.
In short, there’s still uncertainty over how high rates will go, and more importantly, how long they’ll stay there.
Given that the Fed is likely to remain relatively hawkish in the near term, short-duration bonds continue to provide investors with compelling yields at low risk.
Short-term bond yields currently range between 3-5%, which is compelling from a risk-reward standpoint:
Long-dated bond yields are actually lower, as markets are pricing in an impending economic slowdown. US 10-year treasuries, for example, are currently yielding around 4%.
Corporate bond spreads (the difference in yields between a corporate bond and a government bond of the same maturity) are at a historical low.
Equity valuations are no longer cheap, and company earnings could be at risk if the US slips into a recession.
Short-duration bond yields are also attractive compared to inflation. While US inflation is still high at 6.4% as of January, it’s on its way down. Economists – and the Fed itself – expect it to end the year closer to 3%. And with short-dated Treasuries currently yielding upwards of 4.7%, that points to positive “real returns” – or returns after accounting for inflation.
Bonds play a key role in balanced portfolios by providing:
Diversification - bonds can offset some of the volatility of stocks in a balanced portfolio.
Income generation - bonds provide investors with income via periodic interest payments. This is especially relevant in the current economic environment given that short-term bond yields are still at decade highs.
Capital preservation - given their lower risk, short-duration bonds can help preserve the value of your investments through periods of market volatility.
If you’re looking for a safer option for your cash, short-duration government bonds offer decent returns in this period of uncertainty. Investing in short-term bonds also means your funds are more liquid compared to options like fixed deposits. That means you have access to your cash in case of an emergency, or when investment opportunities (such as market sell-offs) arise.
If you’re looking for targeted exposure to USD-denominated short-term bonds, you can get exposure to US government bonds with 1-3 months remaining to maturity via a cash-equivalent asset in our Flexible Portfolio.
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