The era of rock-bottom interest rates may finally be ending.
Long term interest rates were volatile in 2021 as investors grappled with mounting inflation pressures and Covid-19 variants that could slow global growth. US Treasury yields, for instance, rose steadily in the first quarter, fell throughout the spring and summer, then began climbing again as the year wound down. Where we go from here will have important implications for portfolio construction and the broader economy.
Investors should be prepared for tighter monetary policy in 2022. If there was any doubt about the future path of monetary policy, the Fed removed it late last year when it announced it would speed up the withdrawal of monetary stimulus and signaled three 25-basis point rate hikes in 2022 as it seeks to counter rising inflation. We think the persistence of high inflation has pulled forward policy normalization. We expect the Fed to deliver the first of four rate hikes in March and we believe the risks are skewed toward more tightening, depending on financial conditions and inflation dynamics. The Bank of England last year became the first major central bank to raise rates since the pandemic began, and central banks in Canada, New Zealand and Norway may also be well into the normalization process by mid year.
Interest rates and bond yields are likely to rise from current levels in 2022. How high they go may depend heavily on the path of inflation. A sharp move higher could result in negative returns for the most interest rate sensitive securities. But economic fallout from the continued spread of the Omicron and Delta variants could limit the upside in yields, as could non-US investor demand for higher-yielding Treasuries.
Still, it is important to remember how low interest rates and bond yields are from a historical perspective (Exhibit 3). Even in a somewhat benign inflation environment, we believe interest rates are headed higher and that the risk/reward tradeoff for investors favors alternative income generators and unconstrained strategies that are designed to pursue returns across multiple sectors, asset classes and geographies without adhering to a benchmark.
Exhibit 3: Nominal interest rates are at record low levels
Source: Bank of England, Goldman Sachs Global Investment Research. As of September 20, 2021.
Keep up to date with what’s happening in markets with the latest insights from Goldman Sachs Asset Management.
Shorter Duration and Diversification
Short- and ultra-short-duration fixed income strategies have exhibited lower risk in a rising rate environment. Compared to longer-duration strategies, multi-sector fixed income, multi-sector credit and select high-yield strategies, meanwhile, may deliver sufficient income to offset price declines in a rising rate environment. Further, diversified exposure across fixed income spread sectors is important as central banks gradually withdraw global liquidity. Bank loans, securitized credit and other floating-rate securities may offer insulation against rate hikes and should do well if economic growth remains strong. We favor selective exposure to EM debt. Rising rates may also provide an opportunity for investors to redeploy cash in higher-yielding assets.
Private Credit Opportunities
Private credit transactions, including flexible and complex financing deals, may also offer floating-rate income while private asset financing can offer diversification, as these loans are securitized against differentiated cash streams, including hard assets and royalties.
Selective Equity Exposure
Public equities have typically been resilient in a rising rate environment, provided that strong growth persists. Investors may want to consider strategies that target stocks with sufficient earnings growth and balance sheets with termed-out debt to offset the potential risk associated with a higher cost of capital. Strategies that can be selective when it comes to growth stocks, which have higher implicit duration risk given their longer-dated cash flows, are also likely to benefit. Cyclical equities, particularly banks, tend to do well when rates rise.
