• A hawkish shift in the Fed’s tone triggered a negative response in U.S. financial markets in January, sending bond yields higher, spreads wider, and making it the worst January for the S&P 500 since 2009
  • Fixed income markets are pricing in approximately 5 rate hikes in 2022, but uncertainty remains related to the Fed’s preferred path to removing monetary accommodation in the near term
  • The sharp rise in yields is negative for depository bond portfolio valuations, but bank stocks outperformed the broader market in January as higher yields boost the value of deposit franchises

The first month of 2022 was one broad financial markets would like to forget. As discussed in last month’s commentary, investment-grade fixed income had a tough year in 2021, particularly in the fourth quarter, but in January, U.S. equities and other risk markets joined the struggle. The S&P 500 posted a -5.17% return in January, its worst month since March 2020 and the worst January return since 2009. High-yield corporate debt, which performed very well in 2021, also had a terrible month, underperforming duration-matched Treasuries by 152 basis points (bps).

There have essentially been two big questions driving markets recently, and both center on uncertainty related to future actions of the Federal Reserve. One, what will be the path of short-term interest rates, and two, how/when will the Fed normalize its balance sheet? The bond market has been working on the first question for much of the last four months, and by year-end 2021, short-term rate markets were already pricing 3-4 rate hikes in the coming year. However, most communication from Fed leaders since that time, including the January 26 FOMC meeting, portrayed a central bank concerned that it was too tardy in its response to well-above average inflation and growth rates. As a result, markets are now pricing for approximately 5 rate hikes this year and another 2 hikes in 2023 (all 25 basis points), and the 2-year Treasury yield rose another 45 bps in January.

The other big question is when and how the Fed will reduce the size of its balance sheet after ballooning by more than $4 trillion since the onset of COVID. The minutes of the December FOMC meeting surprised market participants by opening the door to potential normalization in 2022. It also revealed that “almost all participants” favored initiating balance sheet runoff at some point after liftoff and that it would likely happen sooner “than in the Committee’s previous experience.” This sparked market pricing, at least partially, for normalization in the second half of the year, which had the biggest impact on fixed income spreads, risk assets, and long-end Treasury yields. In other words, the poor performance across most financial assets in January wasn’t just about the market pricing for a couple of extra rate hikes. It was more about expectations of a ~$9 trillion balance sheet potentially shrinking at a much more rapid pace than previously anticipated. That said, perhaps more important for fixed income markets is the approach to normalization that the Fed will take. Recent guidance from the January FOMC meeting suggested a preference for letting MBS positions pay down as opposed to outright sells, which would be less negative for MBS spreads. A more aggressive unwind would be negative for all spread assets, but all indications from Fed leaders at this point would suggest such a scenario would be a last resort in the battle against inflation.

This is not a simple task for Fed leaders from this point forward, and for market participants, there is still notable near-term uncertainty. The January 26 FOMC meeting provided relatively clear certainty on two fronts, that liftoff would happen in March, and asset purchase tapering would finish that same month. Beyond that, there were no more clear answers, despite reporters’ best efforts to press Fed Chair Powell following the meeting. He was asked specifically whether liftoff would be a 50-bps hike, which he refused to close the door on, but to be fair, he also said they haven’t even discussed it. He also refused to commit to forward guidance of a quarterly rate hike schedule similar to what was done during the last Fed tightening cycle. Instead, Powell emphasized that the economy and inflation are very different now relative to the 2016-2019 timeframe, leaving the door open for rate hikes at every FOMC meeting if supported by incoming data. As such, financial markets may remain more volatile over the next two months as fresh inflation and other important economic metrics are released ahead of the March 16 meeting.

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