Capital Group: Better outlook as Fed slows rate hikes

2022 was not an easy year for bond markets as the US Federal Reserve sharply raised interest rates to suppress inflation. As the end of rate hikes draws to a close, many financiers will be wondering if the volatility will end in 2023 and a period of relative calm will begin.

At the December meeting, the Fed opted for a dovish approach, raising interest rates by half a percentage point to a range of 4.25% to 4.50%. After four consecutive 0.75 basis point interest rate increases by the Federal Reserve to quell inflation, this relatively low interest rate hike was good news for investors. But the Fed has indicated that interest rates will be raised to around 5%.

There are still major challenges ahead. Ex: Inflation remains high and the economy is expected to slow or contract.

Inflation has likely peaked, but is likely to remain high

Even the most optimistic investors are bracing for a recession. The question is rather how big or deep the deflation will be as central banks around the world raise interest rates to rein in inflation. Is growth in major economies, including the UK, EU, Japan and US, expected to stagnate or contract in 2023?

It is clear that demand for sectors that are quick to raise interest rates, such as housing, has decreased. Other economic sectors will take longer to calm down. “The impact of higher interest rates will be felt in the coming months and is likely to be reflected in higher unemployment, lower job opportunities and lower retail sales,” said Portfolio Manager Richie Tuazon.
So far, the economy has handled this surprisingly well. But paradoxically, it is precisely the bright spots that can amplify the problem of inflation. “The supply chain issues appear to have resolved themselves, but tight labor markets and consistent wage increases could keep inflation above the Fed’s 2% target for some time to come,” Tuazone said. Geopolitical risks can undermine the Fed’s actions.

“Stagflation lurks,” Tawazon said. The dreaded combination of stagnant economic growth, high unemployment and soaring prices calls for a proactive approach to investing in bonds. “I see opportunities within the yield curve on government bonds as well as Treasury inflation-protected securities.”

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