Tom Wald, CFA®, Chief Investment Officer, Transamerica Asset Management, Inc.
In this article we review:
Our perspective on the recent Fed meeting and path of future rate hikes
A potential conclusion of the Fed’s current tightening cycle by midyear
Market implications of the presently inverted Treasury bond yield curve
What this could mean for investors in the year ahead
As expected, the Federal Reserve raised the federal funds rate by 0.25% to a target range of 4.50%–4.75% at its February meeting, reflecting its smallest rate increase since March of last year. Regarding this development and the overall interest rate environment, we believe the following points are pertinent for investors:
We see two more 0.25% rate hikes between now and midyear, thereby concluding the current tightening cycle. It would be our best assessment the Fed will increase the fed funds rate by one-quarter point at both its upcoming March and May meetings and then hold tight (pardon the pun) for the remainder of the year. Given the Fed’s initial error in judging inflation to be transitory at its outset, as well as how the Fed will likely interpret the unexpectedly strong January employment report, we believe they will be reticent to reduce rates potentially too early and risk a resurgence in consumer prices.
The disconnect between Fed public commentary and market expectations continues, although we believe this should not be a material issue for the markets. There continues to be wide disparity between ongoing commentary from Chair Powell and other Fed officials implying the fed funds rate will likely move to a lower bound of 5% in the months ahead and remain there for some time, versus current federal funds futures market expectations of two rate cuts in the second half of the year. While it would be our judgment that rate cuts in 2023 are unlikely, we also believe markets could still react favorably to a conclusion of rate hikes by midyear.
The yield curve is now substantially inverted, and this favors short-term bonds. The absolute level of yield differential between the 3-month and 10-year U.S. Treasury bonds has reached its widest inverted margin in more than four decades (1.05% as of February 7) and on a percentage of yield basis close to its widest ever (4.68% vs. 3.63%). Over the past 50 years, there have been six previous inverted 3-month to 10-year yield curves varying in length from four to 17 months, with an average of 10 months before resuming an upward slope. Therefore, we would be cautious on longer-term bonds and favor the short-term bonds given the current curve has been inverted since October.
Even without rate cuts later in the year, we still believe the conclusion of rate hikes by summer could prove to be a catalyst for the markets. We feel markets could be well positioned for upside if the Fed concludes raising rates by about midyear and core rates of inflation decline into the 4% range. We continue to expect a year-end lower bound on the fed funds rate of 5% and believe a realistic yield on the 10-year Treasury bond for this time frame to be about 4%. We also maintain our year-end target on the S&P 500® of 4,400.
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Past performance does not guarantee future results. Indexes are unmanaged and an investor cannot invest directly in an index.
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Fixed income investing is subject to credit rate risk, interest rate risk, and inflation risk. Credit risk is the risk that the issuer of a bond won’t meet their payments. Inflation risk is the risk that inflation could outpace a bond’s interest income. Interest rate risk is the risk that fluctuations in interest rates will affect the price of a bond. Investing in floating rate loans may be subject to greater volatility and increased risks.
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The information included in this document should not be construed as investment advice or a recommendation for the purchase or sale of any security. This material contains general information only on investment matters; it should not be considered as a comprehensive statement on any matter and should not be relied upon as such. The information does not take into account any investor’s investment objectives, particular needs, or financial situation. The value of any investment may fluctuate. This information has been developed by Transamerica Asset Management, Inc. and may incorporate third-party data, text, images, and other content to be deemed reliable.
Comments and general market-related projections are based on information available at the time of writing and believed to be accurate; are for informational purposes only, are not intended as individual or specific advice, may not represent the opinions of the entire firm, and may not be relied upon for future investing. Investors are advised to consult with their investment professional about their specific financial needs and goals before making any investment decisions.
The 10-Year U.S. Treasury bond is a U.S. Treasury debt obligation that has a maturity of 10 years.
S&P 500® Index: An unmanaged index of 500 common stocks primarily traded on the New York Stock Exchange, weighted by market capitalization.
Transamerica Asset Management, Inc. is an SEC-registered investment adviser. The funds advised and sponsored by Transamerica Asset Management, Inc. include Transamerica Funds and Transamerica Series Trust. Transamerica Asset Management, Inc., is an indirect wholly owned subsidiary of Aegon N.V., an international life insurance, pension, and asset management company. 1801 California Street, Denver, CO 80202, USA.
