Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial
Josh Whitmore, CFA, Sr. Fixed Income Analyst, LPL Financial
TAKING ADVANTAGE OF HIGHER YIELDS
The LPL Research Strategic and Tactical Asset Allocation Committee is increasing its recommended interest rate exposure in its tactical allocation from underweight to neutral. Now that interest rates have moved substantially higher, we believe opportunities in fixed income have improved and are looking to add back to certain areas within fixed income that may benefit.
Because the equity risk within our diversified asset allocation portfolios is still the largest contributor to total portfolio risk, we like the defensive properties that bonds could play on a go-forward basis. In the form of high-quality bonds, interest rate exposure has been a good diversifier to equity risk. And while that hasn’t been the case this year, we think at these higher interest rate levels, bonds can act like that diversifier again. While we acknowledge that interest rates could move higher still, we think the risk/reward profile of adding to rate-sensitive fixed income assets has improved. That said, for those income-oriented investors who mostly or exclusively hold bonds and don’t need fixed income to diversify stock holdings, we think there are ample opportunities in shorter maturity Treasury and investment-grade corporate securities.
A Historically Aggressive Fed
In last week’s Weekly Market Commentary, we wondered how much higher interest rates could go. The yield on the 10-year U.S. Treasury yield is up over 3.0% from its August 2020 lows and has already seen the biggest move higher in yields since 1987, when rates moved higher by 3.2%. Since the 1980s, the average trough-to-peak increase in 10-year Treasury yields has been closer to 2.5%, but that includes large rate increases in the early ‘80s when Treasury yields were much higher. Since 2000, the average increase in the 10-year yield during major moves higher is around 1.8%. Clearly, we’re not in normal times, but the move on the 10-year Treasury yield since it bottomed in August 2020 has been significant. As such, yields on most fixed income instruments are trading above longer-term averages.
The significant increase in yields, especially this year, is because of changing Federal Reserve (Fed) rate hike expectations. In late 2021, markets expected the Fed to largely stay on the sidelines and keep short-term interest rates low. However, as inflationary pressures remained (and still remain), the Fed has embarked on a historically aggressive rate hiking campaign [Figure 1]. Because of the Fed’s stated desire to front-load rate hikes, the current rate hiking cycle is the most aggressive campaign since the early ‘80s in both the speed and magnitude of rate hikes. The Fed has signaled that more interest rate hikes will likely be necessary to arrest the generationally high consumer price increases we’re currently experiencing. Markets have already priced in what we think is an appropriate terminal fed funds rate. As such, we think we may be at or near peak “hawkishness” from the Fed, which should allow fixed income yields to stabilize at or near current levels.