This year’s sharp rise in treasury yields creates an attractive opportunity in short-term bonds heading into 2023 as the Fed slows the pace of rate hikes. The Fed is set to deliver a fourth 75 basis point hike in November, raising the target Fed Funds rate to 3.75-4.0%.
With Fed Funds in a range that Fed officials deem to be restrictive, we expect the FOMC to be more cautious going forward as dramatically tighter financial conditions work their way through the economy. We anticipate the Fed slowing to a 50 basis point hike in December before another 25 or 50 basis point increase in February. Merely slowing the pace of hikes will provide a welcomed sense of relief to markets and short-term bonds.
We favor transitioning from floating-rate notes to fixed-rate notes going into 2023 now that interest rates have reset at considerably higher levels and as the Fed nears the end of its hiking cycle. Two-year U.S. Treasury notes yield around 4.50% today, their highest level since 2007. High-quality two-year corporate bonds yield north of 5.0% as 1-3 year investment grade credit spreads are at 2-year highs, reflecting recession fears. At these levels, bond investors can once again benefit from locking in attractive yields and steady income before the market begins to earnestly expect a rate cut.
The market is expecting the Fed to cut as soon as next summer, but we believe the current odds of 20% could rise in the coming months. Slowing economic growth and the Fed’s front-loaded hikes may pull forward the prospects of a Fed pause, which would favor fixed-rate securities going into the new year. While inflation may be uneven and remain stubbornly high over the next six months, the pandemic-induced fiscal pressures and supply chain issues that caused it will continue to dissipate as consumer savings rates fall and supply and demand forces normalize.
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