- As the Fed turns more hawkish on policy, the U.S. yield curve could flatten or invert.
- The Fed can avoid a yield curve inversion by pivoting toward the balance sheet.
- The outlook for economic growth — currently elevated — can weigh on valuations.
We expect the Federal Reserve to start reducing accommodative monetary policy more aggressively in 2022. The Fed will likely scale back its bond buying more quickly starting in January and raise interest rates three times next year. These policy changes will have implications for the U.S. Treasury market and other financial assets, conveyed through gyrations in the Treasury yield curve.
Demand for safe-haven investments
The Fed could raise the policy rate — currently near zero — in 2022, assuming there are no long-lasting shocks from the Covid-19 pandemic or other events. This might begin as soon as June. Yet, the rise in longer-duration bond yields would be limited. The U.S. yield curve would continue to flatten, and the curve could invert. A flatter or inverted yield curve isn’t that unusual when the Fed is turning more hawkish. If this happens, the Fed may scale back rate hikes, because an inverted curve would hinder the smooth functioning of financial markets.
The Fed’s moves will guide yields on shorter-dated Treasuries (the front end of the yield curve). But yields on longer-dated bonds (the back end of the curve) will be determined by supply and demand. Yields move inversely to bond prices. We believe the rise in long-term bond yields will be limited due to steady demand. Overall, Treasury issuance and corporate bond sales will likely slow next year compared with 2021. Slowing growth and the safe-haven status of Treasuries indicate they will continue to play a role in portfolios even as private sector investors may look to potentially higher returns from equities and alternative assets.
Holdings of U.S. Treasury securities in global portfolios
Source: Putnam Investments calculations, as of November 30, 2021.
Past performance is not a guarantee of future results.
Persistently high inflation and a tight labor market require monetary tightening. However, raising the policy rate more than expected can invert the yield curve. The Fed can utilize another tightening tool in hand, shrinking its balance sheet, to avoid the inversion of the yield curve. Policymakers may make adjustments to the central bank’s balance sheet, which have a greater impact on the back end of the yield curve.
By scaling back its bond holdings along with or ahead of rate hikes, the Fed can minimize the risk of the yield curve inverting. Several members of the FOMC have discussed the end to reinvestments, a passive and more orderly way to reduce the balance sheet. We expect the Fed to announce a passive balance sheet reduction by setting caps on reinvestments in 2022. This could come before rate increases.
Risk assets and the yield curve
Rate-hike expectations may stay elevated until the end of the first quarter of 2022. But the rise in 10-year U.S. Treasury yields, or other longer-dated risk-free bonds, will be contained, in our view. Many — but not all — risk assets would likely benefit from this combination. Until now, the dollar has rallied as investors bet on higher policy rates. Emerging market (EM) local bonds, however, have sold off.
Many EM central banks have raised their policy rates as the dollar appreciates against their currencies. The dollar can reach fresh highs as investors mull further tightening measures by the Fed but is likely to peak at about the same time. Local rates in EM will probably top out by then. On the flip side, while the dollar and EM rates are about to stabilize, other assets could come under pressure.
A rise in longer-duration bond yields, whether from balance sheet reductions or other means, could lead to high volatility for risky assets. Attempts to steepen the yield curve, or raise real rates, are likely to trigger a repricing of financial assets. We could see volatility as soon as the balance sheet discussion starts, likely toward the end of March or early April.
Looking for stability
Risk assets should begin to recover once the financial markets price in the Fed’s balance sheet runoff. How long and how far the winding down goes will depend on economic activity, inflation, and other policies. It is possible the Fed and other central banks will attempt to slowly exit the government bond market altogether. If this happens, there could be a gradual uptrend in Treasury rates, limiting gains in risk assets.
Another key factor for valuations is growth. We believe the markets’ growth estimates for 2022 remain elevated. Investors have yet to price in a “living with the virus” scenario. A less accommodative monetary policy and fluctuations in Covid-19 infection rates may signal the new normal, in our view. Full recovery in some sectors may be years away. Financial markets may need to downgrade their growth outlook for next year and beyond. Growth in 2022 will be supportive of risk assets, but less so than this year, in our view.
The worst case for financial markets
Despite our relatively strong outlook above, there is a risk that infection rates could surge, governments could reimpose strict restrictions, especially in Europe, and global growth comes down more significantly. In this scenario, inflation would remain high, but the yield curve could flatten more quickly and significantly, and a Fed policy mistake becomes a possibility. The yield on the 10-year Treasury note can continue to drop, while short-dated bond yields remain high. The Fed might back off from raising rates yet still signal an end to reinvestments.