Increase in interest rates as a yield driver?

Worldwide, inflation rates are still at a high level. Now the Fed has announced its first interest rate hike for March. Dr. Volker Schmidt, Senior Portfolio Manager at Ethenea Independent Investors S.A, looks at the implications this decision has for the yield curve. ​

At its meeting in January, the Fed stated that it would soon be appropriate to raise the target range for the Federal Funds rate in light of inflation well above 2% and a strong labour market. “The so-called ‘dot plot’ presented by the central bankers in December already envisaged three rate hikes in 2022. While the policy rate, the Fed Funds target range, has remained unchanged since 2020 at 0% - 0.25%, longer-term yields reacted much earlier to economic improvements and increased inflation,” says Dr Volker Schmidt. “The 10-year Treasury yield rose from 0.9% in early 2021 to 1.75% at the end of the year, implying that some rate hikes are already priced in.”

The Fed’s increasingly hawkish stance, formulated by Jerome Powell during his testimony before the Senate Banking Committee, caused yields to spike to 1.9%. However, this increase was accompanied by significant stress on the US equity market, in particular the highly yield-dependent NASDAQ index, which fell by nearly 20%. This halted the upward trend in yields. Therefore, the development of the 10-year yield will not only be driven by the actual pace of interest rate hikes and the stability of the equity market, but also by the pace of the Fed’s balance sheet reduction. Volker Schmidt explains: “Given these partially offsetting factors, in 2022, we expect the 10-year yield to rise only moderately from current levels and to remain below 2.5% throughout this year. As we expect the number of rate hikes to remain close to the forecast presented by the Fed in December, and not to rise to seven hikes in 2022 as suggested by some observers, we expect the yield curve to remain upward sloping and not to invert.” In this respect, the currently very flat curve between the 5-year and 10-year US Treasuries is likely to steepen.

Treasuries as a valuable portfolio component

“We prefer short to medium-dated Treasuries in our portfolios. The yields on 5-year Treasuries have risen from 0.4% at the end of 2020 to 1.25% at the end of 2021, and again to 1.6% in January 2022. We have also seen similar moves for the 2-year and 7-year Treasuries,” says Volker Schmidt. “This implies that a number of interest rate hikes have already been priced in and leads to a coupon which, at least, gives a somewhat positive return. Inflation in the US is currently above 7% and is likely to remain at this level or even rise further during the first quarter of this year.”

Current inflation rates overstate the underlying trend, as they are calculated as the increase to the levels at year-end 2020, which were very subdued due to the pandemic. “We expect a similar process to occur in one year’s time, but this time in the opposite direction. The is because next year’s figures will be calculated compared to the current excessive pricing based on peak demand and growth, which is likely to weaken over the course of the year,” Schmidt say. “As a result, uncertainty about future inflation is likely to remain high and the Fed is expected to opt for a temporary slowdown in rate hikes as we approach 2023. The major risk for the aforementioned range of maturities is the possibility that the Fed will have to act faster and, as a result, will raise its target range to around 2% in 2022. However, should this be the case, losses should be moderate and partly offset by coupons and a steep yield curve in this maturity bucket.”

Volker Schmidt
Volker Schmidt

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Wim Heirbaut

Senior PR Consultant, Befirm

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