Mike Sanders, Head of Madison Fixed Income, provides an outlook and review of fixed income markets, including an outlook on the Federal Reserve (Fed) rate hikes and quantitative tightening, opportunities in corporate bonds, and why active fixed income management is best suited for today's environment.
It was interesting, entering the year, pretty benign expectations with respect to growth, slowly increasing growth, slow inflation. You know, really post the election in Georgia when more fiscal stimulus was getting priced in, the markets really took off. 10-year rates rose to 1.75%. You know, risk assets fared pretty well during that period. Corporate bonds moved pretty much sideways most of the year and ended up outperforming treasuries but roughly unchanged with respect to spreads. I think towards the end of the year, there was more concern as inflation became less transitory and more permanent, using Powell’s terminology. And the market started to price in a higher probability of hikes coming sooner than what they thought maybe to begin the year.
So themes in 2022, it really comes down to Fed right. The Fed is, is dealing with higher inflation than they what they really want, and a jobs market that's been a lot tighter than in past cycles. In addition, they're in the middle of an election cycle with inflation being a key issue with voters. So, in the most recent FOMC meeting in January, Chairman Powell noted that there's a lot of room for rate hikes, and the economy can really take more tightening policy than what maybe the investors thought the year they could.
If you couple the 1.75% terminal Fed funds rate with where inflation is running long term, that would still imply a negative real Fed funds rate. And historically speaking, the Fed needs to get to have a positive real Fed funds rate and so you either have to have inflation come down a lot or they have to raise policy a lot farther than what the market’s pricing. And I think that's going to be the key to positioning a portfolio in 22 is deciding how far the Fed has to go to fight inflation because they’ve clearly become concerned with where it's at.
We're pretty confident that you'll have a march liftoff for the first Fed rate hike. The big question with respect to policy is really what happens with the balance sheet.
The Fed has over $8 trillion worth of securities on their balance sheet. It's a significant amount, relative to previous instances of quantitative easing. And the Fed doesn't want to be in the business of owning a lot of bonds. They've indicated they don't want to hold mortgage-backed securities in the long run. And I'm sure they would prefer to own less treasuries in the long run as well. And so the timing of the Feds explicit run off of the balance sheet is I think, a bigger issue than the number of fed fund Fed funds rate hikes.
The corporate bond market had a really flat kind of performance in 2021. You know, spreads didn't move a ton. But there was additional yield to be earned over treasuries. From a fundamental standpoint, fundamentals couldn't really be better for corporate bonds, flush with cash, companies have termed out their debt, there's not a lot of near term maturities that they have to do. Our concern in the bond market is that it's almost too good. In the sense that the ability for firms to do M&A activity, mergers and acquisition activity, is has been heightened because they have such good strong balance sheets at the moment. And so we're concerned about certain industrial names, in particular, going and executing on shareholder-friendly activity, versus kind of balancing that versus what fixed-income investors would want.
So, the easy money and corporate bonds has been made. You know, it's, you have to be a bond picker in today's environment. You know, you have certain firms that are going down different paths with respect to ratings and leverage, and the ability to buy any corporate bond that maybe you saw in the middle of 2020 isn't there anymore.
In the current environment, an investor might want an active fixed income manager because of all of the very unique risks that are currently in the market. You have very tight corporate bond spreads, along with hawkish monetary policy, and a lot of uncertainty down the road. The ability to make money by buying any corporate bond is over. Corporate bond spreads are very tight, and there are a lot of risks out there from companies leveraging themselves up to do specific deals. Additionally, certain parts of the bond market are also underpricing the risks of maybe a more aggressive fed than what we've seen in past cycles. And so, when you think about an overall asset allocation, you don't want your fixed-income portfolio to act like your equity portfolio in times of volatility. Recent periods have shown that longer duration fixed-income assets are correlated with certain parts of the equity market, and what you don't want is for both your bonds and your stocks to go down a lot at the same time, what you really want is a negatively correlated asset. And an active manager that's managing all the fixed income risks, whether its duration, credit, curve, you know, will be able to better manage through these kinds of environments and provide that negatively correlated asset.