Fixed Income Commentary – January 2022

Happy New Year!


Bond yields rose modestly in December in a fitting end to the year: COVID is still a significant problem, but the economy is showing its resilience, growth and inflation remain firm, and rate hikes are now on the horizon for 2022. As a result of higher Treasury yields, the total return for the Bloomberg U.S. Intermediate Aggregate Index was slightly negative: -0.12% for December and -1.29% for the full year. These results were worse for Treasuries, while corporate bonds, mortgage-backed securities, and municipal bonds outperformed for both periods. Demand for municipals in particular remains solid and fundamentals are generally sound as well.

Turning to monetary policy, the Fed provided an extraordinary amount of support to the markets and the economy since the start of the COVID pandemic in early 2020. With inflation running hot due to unprecedented supply bottlenecks combined with strong demand for goods, and with the unemployment rate nearing 4%, the Fed is now slowly moving away from its ultra-loose policy stance.

After its meeting in December, the Fed revealed a bit more detail on the monetary policy front:

  • The pace of tapering (gradual reduction in the Fed’s monthly Treasury and MBS buying) will accelerate and will conclude in mid-March, putting an end to QE (quantitative easing) and balance sheet expansion.
  • The dot plot revealed three rate hikes are likely in 2022 and another three in 2023. This median expectation has been edging higher and could continue to do so if inflation persists and if signs of a tight labor market grow more plentiful.
  • A discussion on the size of the Fed’s balance sheet which is approaching an astonishing $9 trillion in size has now begun, revealing that most Fed governors do not believe an extended delay will be required before the balance sheet should begin to decline (otherwise known as balance sheet runoff).
  • The annual rotation of voting regional Fed presidents that occurs each January will bring a hawkish shift to the FOMC (based on public statements) and three Board seats remain unfilled. While Jerome Powell will remain chairman, the composition of the Fed will no doubt prove fertile ground for media speculation as the year unfolds.


Fed policy aside, the bond market remains very accommodative for borrowers. Yield spreads, or the amount of yield issuers need to pay above Treasuries in order to entice buyers, are at low levels historically. There is a great deal of demand for corporate and municipal bonds, and any large issuer of bonds is able to get their deal done with ease. Conditions like this make debt-financed corporate take-overs more feasible. Even if the Fed carries out the plan outlined above, government bond yields will remain low for the foreseeable future and their actions are unlikely to change the liquidity dynamics of the bond market.

In the parlance of monetary policy, these conditions enable the flow of credit to households and businesses, and maintaining stable financial conditions is a non-official but important goal of the Fed. Of course, the bond market is not the only determinant of financial conditions — the equity market plays an important role as well. Low volatility in equities along with the positive trend of higher prices are two indications of favorable market conditions.

Finally, bank lending standards are another important element of financial conditions, and recent reports show an easing of lending standards for nearly all types of loans. This is what banks do when they are confident about the prospects for their customers. The take-away: the banking industry is healthy and eager to make loans to consumers and businesses alike.

As we look ahead to the new year, here are a few things we expect:

  • A slower pace of real GDP growth compared to 2021 and consumption more in line with pre-pandemic norms, or less goods consumption and more spending on services.
  • Above-trend inflation for the first half of 2022 but trending lower in the back half of the year assuming supply bottlenecks begin to fade.
  • Labor market shortages persisting unless those who have left the labor force come back in droves; this tight labor market should bode well for continued strength in wage gains, but that will not necessarily prove inflationary if productivity improves.
  • Lower commodity prices as demand from China tapers off and other supply constraints ease. One notable exception may be agricultural commodities, which could stay firm unless weather conditions return to more normal patterns.

 

 

 

Whatever happens in 2022, we at Maple Capital Management look forward to working with you for all your investment needs. We invest with the long term in mind and we are excited about many new advances that could be quite impactful for certain industries and companies, and for productivity, which is important for economic growth.

Stay safe, enjoy life, and keep your eye on the long term. Best wishes from all of us for 2022.