Inflation, Interest Rates, and an Invasion

By Kevin Kelly, Portfolio Manager

Both fixed income and equity investors came into 2022 concerned about rising interest rates and inflation. Then the Russian invasion of Ukraine occurred, forcing investors to consider the significant humanitarian, geopolitical, and economic impacts of a major military conflict. Clearly, the combined effects of rising interest rates, high inflation, and the invasion of Ukraine make the current investment environment challenging. However, we do think a disciplined fixed income approach that is focused on taking only moderate levels of interest rate and credit risk can be effective while such investment uncertainty persists.

Headline inflation (CPI) has been 5% or higher since May 2021, but in the past three months has accelerated to 7% or higher with the latest data point being 7.9% in February. The sanctions on Russia, while necessary, will exacerbate inflation in the near-term. Furthermore, sanctions naturally complicate the outlook for both businesses and investors. The scarcity and shortage concerns for all commodities and goods sourced from Ukraine and Russia is significant. These existing or pending shortages have caused major commodity inflationary pressures notably in oil, liquified natural gas, wheat, and nickel to name a few. There is the potential that if sanctions remain for a long period of time that these economic impacts will become the new normal and the commodity price reset could be permanent. If supply chains get realigned to match permitted trading partners, a less efficient, but semi-stable resolution can be achieved. While this seems nice in theory, this will be a very difficult process that may require painful adjustments. Consumers, businesses, and countries, however, will adapt to reduce the consumption of those commodities, goods, and services which experience significant inflation. We will continue to actively monitor inflation data points to position fixed income portfolios appropriately. Short and medium-term interest rates have been rising as inflation has remained stubbornly high, which has investors further realizing the Federal Reserve must raise rates to help reduce inflationary pressures. Additionally, the Fed recently ended its bond purchases after nearly two years of massive buying of both Treasuries and mortgage-backed securities. We expect the Fed to hike the Federal Funds rate at next week’s meeting by 0.25%. Beginning in late March, the Fed will likely become a net seller of Treasuries and mortgage-backed securities as it lets its balance sheet shrink over time. The market has also seen interest rates increase as the Fed’s super accommodative policy normalizes.

Important clarification regarding interest rates and Fed Funds rate:
Regarding interest rates, investors must remember that interest rates on Treasury bonds and the Fed Funds rates are not the same thing. Interest rates refer to the yields on U.S. Treasury bonds, which are the risk-free rates in the U.S. at various maturities. The Federal Reserve’s primary policy tool is the Federal Funds Rate, which is the overnight rate at which banks borrow and lend excess reserves. For example, the 2-year Treasury rate now yields ~1.75% while the 3-month Treasury yields ~0.4%. The 2-Year is higher because the market currently expects the Fed to raise short-term interest rates, the Fed Funds Rate, by approximately 1.75% by February 2023 (or 7 hikes of 0.25% increments).

While the fixed income market is down significantly less than the equity market in 2022, the fixed income market has provided very few hiding places as interest rates rise and credit spreads widen. The average investment grade bond is down approximately 8%, the average high yield bond is down 5.5%, and preferreds are down nearly 10% (based on the largest preferred ETF). ACM fixed income has performed better than those because we remain very mindful of taking only moderate levels of interest rate and credit risk. We proactively focused on lower duration securities, and we purchased a small position in TIPS to help protect against near-term inflation concerns. While clarity on interest rates, inflation, and the geopolitical uncertainty is fleeting, we do think a conservative, but opportunistic, approach to fixed income will prove productive over time.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.