The Federal Reserve’s hiked interest rates have not eased worries about inflation and growth, causing bond investors to adjust the duration of their portfolios. Such safety trades can mean going short or long, depending on the perceived risk.
This year, Fed Funds Futures, which track short-term rate expectations, have priced in at least three 50 basis-point increases, with more than 250 basis points in cumulative increases. The market is expecting a 2.86% fed funds rate by the end of the year, compared to the current 0.33%.
The U.S. central bank, in an effort to curb inflation, is expected to raise rates again and allow its $9 trillion balance sheet to decrease by about $95 billion per month, beginning in June.
Bond investors have maintained their holdings of short-duration fixed-income securities as they brace against the Fed’s tightening. Bonds of shorter duration typically do better than longer-dated ones when rates are rising.
Some investors may choose to remain neutral with regard to duration.
"Will inflation come down? Will the Fed err on the side of running inflation a little bit hotter than what it has been in the past? We think that's probably going to take a little bit of time to play out,” Jason Clemente, Senior Portfolio Manager at Insight Investment, told Reuters. “There’s still a fair amount of uncertainty.”
Meanwhile, U.S. Treasuries have sold off sharply this year. The ICE Bank of America U.S. Treasury Index fell 8.2%, on track for its worst performance since about 1997.
The shorter-duration ICE BofA 1-3 years U.S. Treasury Index performed slightly better, with losses of 2.7% so far in 2022 and 0.3% for April. "The simplest and lowest-risk solution is simply to reduce or eliminate duration risk," John Lynch, Chief Investment Officer at Comerica Wealth Management, told Reuters. Money market fund yields, which have risen from zero to about 0.25%, should continue to rise, he said, with Fed tightening. Also, ultra-short bond funds, with durations shorter than a year, are outperforming the longer-duration alternatives, with yields rising to about 1.4%.