What You Need to Know
- The Fed is expected to raise rates three times in 2022 and end its asset purchases in Q1.
- The trajectory of the coronavirus pandemic and fate of President Biden's economic plan could upend those expectations.
- Strategists recommend that investors stay in the short end of the yield curve and stick with high-quality securities.
What happens to the U.S. bond market in 2022 will depend largely on the trajectory of the coronavirus pandemic, which is raging again, and Federal Reserve policy — how fast it tapers asset purchases, how high and how quickly it raises interest rates, and whether it begins a series of quantitative tightening, retiring outstanding debt in order to reduce market liquidity.
The Federal Reserve already set the plate for the first two moves at its last policymaking meeting for the year in mid-December. The Fed said as a result of rising inflation and improvements in the labor market, it would double the pace of its tapering starting in January, reducing Treasury purchases by $20 million a month and asset-backed purchases by $10 million. The faster tapering schedule will end Fed asset purchases by mid-March, months earlier than initially expected.
All 18 Fed policymakers indicated in the so-called dot plot that the central bank would raise rates next year, including 12 who expected at least three increases. At the same time, the smaller, 11-member Federal Open Market Committee (it’s short one member) said in its meeting statement: “The path of the economy continues to depend on the course of the virus. … Risks to the economic outlook remain, including from new variants of the virus.”
If the economy continues on its firmer footing and inflation remains “well above the Fed’s 2% target,” as Fed Chairman Jerome Powell expects, then strategists anticipate the Fed will raise short-term interest rates multiple times in 2022 in 25-basis-point increments, and long-term rates will rise from around 1.5% to 2% or slightly higher by year-end.
But if the omicron variant spreads rapidly, preventing the economy from returning to full employment in 2022, and President Joe Biden’s Build Back Better Act doesn’t pass — which is likely since Sen. Joe Manchin, D-W.Va., announced he will oppose it — then the Fed may not raise rates as quickly as many expect.
“If BBB fails completely, then real GDP growth in 2022 will be reduced by 0.5%, and instead of three quarter-point increases in the funds rate in 2022, as investors currently anticipate, there will be only two rate hikes,” said Mark Zandi, chief economist at Moody’s Analytics.
Impact of Rising Rates
Still, bond yields are expected to rise in 2022, for the second year in a row, which will lower bond prices. Investors will again have to choose between collecting higher yields from riskier bonds or lower yields from safer ones.
Given the broader bond outlook, Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, favors short-duration fixed income assets such as bank loans, which have adjustable rates that will rise along with increases in short-term rates, and investment-grade corporate debt maturing in five years or less.