Going into the last Fed meeting for this year, expectations were for a hawkish stance, given recent statements by Chair Powell as well as continued strength in prices. Market expectations were for an increase in the pace of tapering from $15bn/month to $25bn/month and the Fed to hint at 2 hikes in 2022. The FOMC delivered an even more hawkish stance, as they doubled the pace of tapering to $30bn/month and bond buying to end by Mar-22. The Fed indicated 3 hikes in 2022 and also raised inflation forecasts for next year.
However, treasury yields were fairly stable and in fact, the curve continued to flatten. The 2s10s curve has flattened by 75bps since Mar-21, which means that the bond market is trying to signal that a hawkish Fed will likely break the economy. The Fed has a history of turning hawkish at the wrong time, like in 2018, that in turn led to the “Powell Pivot” in Jan-19, after the sell-off in equities.
So, let’s draw lessons from 2018 when the Fed embarked on a hiking cycle. Hikes started mid-17 and ended in Dec-18. During this period, US 10y yields went up 120bps, before peaking in Nov-18 (chart 1). More notably, the curve flattened throughout (chart 2). So, should we sell out of bonds? Long-term treasuries fell 6.5% until May-18, only to reverse all of that move by end of the year. This tells us that even when 10y yields were rising (May–Nov 2018), treasuries returned positive. Also, over the full period, they were roughly flat. Further, during the equity market sell-off in 4Q18, treasuries provided much-needed diversification.
Within equities, we saw S&P 500 return 20% over the period, before selling off 20% in 4Q18. This tells us equity markets can continue their rally even when bond yields are rising. Secondly, the Fed cannot afford a 20% sell-off in equities and is generally forced to shift dovish. Underneath the index, the tech sector had a bull run, barring a 7% sell-off in 4Q18. On the other hand, financials which benefit from rising rates, peaked in Mar-18 (mid-way) and then underperformed till end of the year. This was in spite of the fact that 10y yields peaked only in Nov.
What does this mean for portfolios? We think having learnt from 2018, the Fed is likely to be cautious while adopting a hawkish stance. Hence, we recommend clients to stay invested in equities. Past experience tells us equity rally would continue for some time and it is almost impossible to call the top. However, we would see bouts of volatility and would recommend investors have a balance of passive and active strategies. More importantly, this illustrates that high quality bonds still have a role in portfolios as they hold up quite well during a hiking cycle, while providing diversification. Given the flattening of the curve, we recommend investors to maintain medium duration exposures in portfolios.”