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During the recently held Federal Open Market Committee (FOMC) meeting on December 15, the Federal Reserve Chair provided multiple indications toward taking some aggressive actions to address the historic high inflation in the United States that included reducing the Fed’s bond purchases and the possibility of three interest rate hikes in 2022.
These actions come at a time when the prices of goods and services are rising at historic rates, primarily due to the relatively relaxed monetary policy, to combat the effects of the COVID-19 pandemic, along with supply chain imbalances, which have contributed to the elevated levels of inflation. In the recent FOMC meeting, the committee increased its inflation outlook for 2021 from 4.2% to 5.3% for all items. In addition to tapering its bond purchase program, the Fed chairman also indicated increasing the interest rate three times in 2022, which will be an aggressive yet warranted move to address economic forces.
In this article, we will take a closer look at the recent indications from the FOMC and how these decisions will likely impact the capital markets and, more importantly, fixed income portfolios.
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The Fed’s recent policy pivot to consider a tighter monetary policy comes after the consumer price index rose by 6.8% this year through November. This means these elevated inflation levels are now a real concern and are hurting everyday Americans, including people with fixed incomes.
Post the pandemic era federal stimulus efforts in 2020, the prices of goods and services started rising in mid-2021, and many considered the price increases to be ‘transitory’. However, with the Fed Chair’s recent indication, inflation is here to stay, unless adequate policy changes are made to address the underlying causes. In his remarks, Jerome Powell mentioned, “Economic developments and changes in the outlook warrant this evolution of monetary policy, which will continue to provide appropriate support for the economy.” It’s also important to note recent supply chain imbalances on the global level have contributed to the increase in the price of goods, which will likely be resolved coming into the new year.
The Fed’s stance to combat inflation accounts for global supply chain issues and how tightening the U.S. monetary policy, along with assuming a resolution in supply chain issues, will bring the appropriate support to address rising inflation levels. In the same address, Mr. Powell added, “Generally, the higher prices we’re seeing are related to the supply-and-demand imbalances that can be traced directly back to the pandemic and the reopening of the economy, but it’s also the case that price increases have spread much more broadly in the recent few months.”
These assumptions are also based on the premise we will likely not see another economic shutdown due to the pandemic, which may send world economic markets into another spiral and worsen supply chain imbalances.
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With the possibility of multiple interest rate hikes in 2022, we will likely see a direct impact on all financial markets, including municipal issuances and fixed income portfolios.
The rising interest rate environment means the Fed will start to increase short-term interest rates, which will in turn have an impact on the entire yield curve. However, the fixed income portfolio will likely see an adverse impact with a varying degree depending on the overall duration.
This phenomenon is known as interest rate risk for fixed income portfolios. Interest rates and bond values have an inverse relationship, which means that when interest rates in the market start to go up, bond prices tend to decrease and vice versa. This is primarily due to the fact that, from an investor’s perspective, an existing bond with a lower interest rate coupon will have to sell at a discount in a rising rate environment to compensate for the higher rate coupons for a similar debt that are being sold in the current environment. For example, a bond issued in 2020 with a $1,000 face value @5% coupon with a five-year term will have to sell below the $1,000 face value in 2022, if interest rates have gone up and an investor can buy a similar bond @7% coupon. An investor looking to invest their $1,000, who has the option of buying a bond @7% in the current interest rate environment, will likely seek a discount on the face value of the original bond issue in 2020.
All this means that, if the Fed’s indications hold, fixed income portfolios will likely see unrealized losses into 2022 and forward. However, the rising interest environment might present better reinvestment options at higher coupons.
With the recent Fed announcement, investors might be optimistic with the scope of better returns on their new investments. However, depending on interest rate hikes and their frequency, we may see a slowdown in municipal issuances.
Furthermore, investors might find value in holding their investment to maturity versus trading prior to maturity in the rising rate environment to protect against unrealized losses.
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