Top-Level Takeaways
- A hawkish shift in the Fed’s tone triggered a negative response in U.S. financial markets in January, sending bond yields higher, spreads wider, and making it the worst January for the SP 500 since 2009.
- Fixed income markets are pricing in approximately five rate hikes in 2022, but uncertainty remains related to the Feds preferred path to removing monetary accommodation in the near term.
- The sharp rise in yields is negative for depository bond portfolio valuations, but bank stocks outperformed the broader market in January as higher yields boost the value of deposit franchises.
The first month of 2022 was one broad financial markets would like to forget.
As discussed in the December commentary, investment-grade fixed income had a tough year in 2021, particularly in the fourth quarter. In January, U.S. equities and other risk markets joined the struggle.
The SP 500 posted a -5.17% return in January, its worst month since March 2020 and the worst January return since 2009. High-yield corporate debt, which performed very well in 2021, also had a terrible month, underperforming duration-matched Treasuries by 152 basis points.
Two big questions have driven markets recently, and both center on uncertainty related to future actions of the Federal Reserve. First, what will be the path of short-term interest rates. Second, when and how will the Fed normalize its balance sheet?
The bond market has been working on the first question for much of the past four months, and by year-end 2021, short-term rate markets were already pricing three to four rate hikes in the coming year.
However, most communication from Fed leaders since that time, including the January 26 FOMC meeting, portrayed a central bank concerned that it was too tardy in its response to well-above average inflation and growth rates. As a result, markets are now pricing for approximately five rate hikes this year and another two hikes in 2023 all 25 basis points and the 2-year Treasury yield rose another 45 basis points in January.
The other big question is when and how the Fed will reduce the size of its balance sheet after ballooning by more than $4 trillion since the onset of COVID. The minutes of the December FOMC meeting surprised market participants by opening the door to potential normalization in 2022. It also revealed that almost all participants favored initiating balance sheet runoff at some point after liftoff and that it would likely happen sooner than in the Committees previous experience.
This sparked market pricing, at least partially, for normalization in the second half of the year, which had the biggest impact on fixed income spreads, risk assets, and long-end Treasury yields. In other words, the poor performance across most financial assets in January wasnt just about the market pricing for a couple of extra rate hikes. It was more about expectations of a ~$9 trillion balance sheet potentially shrinking at a much more rapid pace than previously anticipated.
That said, perhaps more important for fixed income markets is the approach to normalization that the Fed will take. Recent guidance from the January FOMC meeting suggested a preference for letting MBS positions pay down as opposed to outright sells, which would be less negative for MBS spreads. A more aggressive unwind would be negative for all spread assets, but all indications from Fed leaders at this point would suggest such a scenario would be a last resort in the battle against inflation.
This market commentary is provided by ALM First Financial Advisors, LLC, the investment advisor for Trust for Credit Unions. Visit trustcu.com to read about the latest economic data and overall market trends.