The Year Ahead: Balancing macro risks & markets

The U.S. economy is moving from a boom phase post reopening toward a moderating period, which, depending on the policy prescription, may end up feeling like a mid-cycle slowdown in 2H22. Historically speaking this is very typical of sharp-growth periods turned more muted. We view the 4% expectations for GDP growth to be higher than what will ultimately be realized, while inflation will remain stubbornly high. The risk of less fiscal support ahead, combined with the Fed combating inflation in 2022, could end up tightening financial conditions materially. This could ultimately push the economy back to pre-COVID-19 (CV19) stagnation or worse – end up shortening the business cycle.

FED POLICY: In our view, Fed tightening is long overdue. In 2022 we expect a minimum of two hikes with the potential for more if the Fed does not start shrinking its balance sheet as we expect in 2H22 (where our quantitative tightening idea, in lieu of hikes, is an out-of-consensus view). We have been pretty vocal that the Fed kept the QE program running longer than needed over the course of 2021. Now comes the tricky part and what amounts to the modern-day Volker-like challenge for the Fed: would they continue a tightening campaign in the face of a material decline in markets.

MONEY MARKETS: The front-end will become more active as the Fed hikes rates and the Treasury re-stocks its cash levels via an increase in T-bill issuance. In addition, the markets will be in the throes of the transition away from LIBOR. In our view the active process of cleaning up and transferring legacy RFR positions will happen in Q1.

TREASURIES: As the Fed embarks on a hiking cycle, U.S. rates are poised to rise over the course of 2022, led by the front-end. However, a number of technical factors (such as lower supply estimates and regulatory-driven demand) should outweigh the fact that the Fed will no longer be buying USTs via QE post Q1. We expect the 2-year UST to absorb the majority of the Fed’s push to higher rates. This will result in flattening trades, moving down the curve into 2s5s, versus the epic move seen in 5s30s during 2021. We actually have a very shallow path for 10s and 30s as the beta to Fed hikes over the years has been reduced. In addition, long duration has proven once again that it is one of the more ideal hedges for risk-off, thus we expect the backend to be bought on dips. We can see additional steepening (versus our forecasts on pg xx) if the Fed does QT. Separately, real rates should rise and the BEI curve to flip from inversion to steepening.

AGENCY MBS: Our outlook for 2022 net issuance is between $600 and $800 billion. Our analysis of the major agency MBS holders suggests as much as $500 billion in incremental demand, which should help offset the exit of Fed support post Q1. The mortgage basis may widen in early 2022 between 25 and 35 as the Fed tapers and removes support for the agency MBS market. Any decent basis widening will likely bring back investors sidelined by the Fed’s recent support of the agency MBS market.

IG CREDIT: We expect spreads to trade within a range of 85-125 bps, as we believe IG spreads are weighted more toward widening than further tightening due to expected rates rise coupled with our macro strategy view of some economic deceleration in the second half of 2022. The 85 bps is close to the full year 2021 average of 89 bps. The 125 bps is the widest level since November 2, 2020, before the vaccine roll-outs. This upper boundary provides a buffer in the event of a more significant FCI tightening in 2022.

HY CREDIT: Our high-yield team remains relatively constructive the product. They expect HY spreads to remain toward the tighter end of our 300-400bp range. With a lower duration footprint versus IG, but still benefiting from strong corporate earnings and low default rates, they expect any sort of spread widening to remain in check. The risks to their view link back to financial conditions tightening more due to a Fed overshoot and/or an adverse reaction in broader markets given elevated risk market valuations.