It is hard to read the news these days and not see something about “high inflation,” “Fed action,” or “rising interest rates.” Of these popular headlines, inflation has garnered perhaps the most attention as we have watched prices accelerate to 8.5% – their highest level in 40 years – following supply chain disruptions and the economy reopening. We feel the impact at the pump, grocery store, and in larger ticket items like buying a house. Unfortunately, inflation has been further magnified by the tragic war in Ukraine, most notably in energy and commodity prices.

As consumers and investors, we are not alone in watching inflation closely. The Federal Reserve, too, keeps a close eye on the readings as one of their key mandates is to keep inflation within a reasonable range. This is accomplished through a process called ‘tightening’, whereby the Fed seeks to balance economic growth against the risk of overheating.

One mechanism in the Fed’s toolkit is the ability to raise interest rates (specifically the Federal Funds Rate), which increases borrowing costs for both consumers and businesses alike, cooling down economic activity/demand. The goal is that, as demand decreases, prices fall to normal levels. Another mechanism in the Fed’s toolkit is a process called “quantitative tightening.” As many of you may recall, the Fed previously employed “quantitative easing,” which was when they purchased longer-term government bonds to increase the money supply and spur economic activity. “Quantitative TIGHETNING” is the exact opposite of this, and the purpose is to SHRINK the amount of bonds on their $9 Trillion balance sheet by letting those bonds mature and “roll off.” Once things get started in May, they have indicated that they plan to allow $95 billion per month roll-off beginning in July. As a result, investors are already starting to price in this shift in Fed policy, and we have been seeing Treasury yields jump up, particularly on the short-end of the curve.

Now that we have all of this as a baseline and can see the interconnectivity of these factors, what does this actually mean for YOU as an investor? The following points shed light on potential risks, important factors to consider, and helpful data to help answer these questions:

Inflation – At a high level, there are currently two main drivers of inflation: (1) Wage Growth, and (2) Supply Chain Delays. On the wage side, there is still a lot of demand for workers yet a lot of job openings. In fact, for every 1 available worker, there is 1.8 jobs available with over 11 Million job openings total. This high demand but low supply of workers is forcing employers to pay up more, leading to the higher wage growth we have seen at 5-6%. Looking at one potential bright side, a recent survey by the U.S. Bureau of Labor Statistics indicated that nearly 1 Million people said they have still not gone back to work due to COVID, which means that these Americans may gradually get back to work since COVID appears to be switching over from pandemic to endemic. Now switching gears to supply chain issues, we are still seeing delays, but there were signs last month that pressures may be moderating, according to the Global Supply Chain Pressure Index. As supply chain delays resolve, pressures on consumer goods prices could abate. On the other hand, we have seen the price for services continues to increase.
bar graph showing goods prices and line graph showing services prices
Rising Rates – As referenced above, your borrowing costs as a consumer go up when interest rates rise (same goes for businesses). This may make you think twice about buying a new home, new car, or other similar purchases where you would normally use financing. Recently, in fact, the average 30- year mortgage rate jumped up to ~5%. On the flip side, as a saver, one positive of rising rates mean that savings and money market accounts, as well as rates on CD’s and investment-grade bonds, will likely be higher in the near-future. We all know that it has been incredibly hard to find a safe alternative to stocks that pays a meaningful yield, but with rates going up, this may change. Of course, as a bond investor currently, you will likely see the market value of your bonds go down on paper given that prices go down as rates go up. However, it is important to keep in mind that a large portion of a bond’s return is the yield (or coupon rate) that it pays, so investors will likely have an opportunity to secure higher-paying bonds in the foreseeable future.
Quantitative Tightening – Following the 2008 Financial Crisis, the Fed’s balance sheet grew to over $4 Trillion as they began to implement Quantitative Easing. After a brief pause in 2019, they began easing again during the pandemic, more than doubling their balance sheet to $9 Trillion. This process boosted liquidity in the market, which helped stimulate the economy and lift asset prices. The Federal Reserve’s huge buying program resulted in a simultaneous increase to bond prices while driving bond yields lower. After all that stimulation, the question is, what happens once they reverse course? Looking at the following chart showing the last time the Fed was both hiking rates AND quantitative tightening (Oct. 2017 – Aug. 2019), one positive sign for equity markets and bond markets is that both experienced appreciation for most of this period. Of course, this was just one period and a different market/economy overall, plus the Fed was not letting bonds roll off at nearly the same level as they plan to now
line graph showing us total assets, s and p 500 total return, and Bloomberg U S aggregate
Yield Curve Inversion & Recession Potential? – A couple of weeks ago, the yield curve inverted when the 2-year Treasury yield briefly eclipsed the yield on a 10-year Treasury (see below “Treasury Yield Curve – 4/1/22” chart). When looking at past 28 yield curve inversions that have happened since 1900, a recession has followed in 22 of those instances. On the surface, it looks as though the latest inversion is most likely foreshadowing a coming recession. However, it’s not that simple, and context is important when it comes to your potential concerns as an investor. First, this inversion lasted a matter of a few days, and the extent (or spread) at which the 2-year exceeded the 10-year was minimal (2-5 bps). Looking back at past inversions that led to recessions, those inversions that lasted longer (1 month or more) and had a higher spread (25-50 bps) were more likely to be followed by a recession. Additionally, even if this latest inversion is predicting a recession, the time it takes for the recession to actually come to fruition is usually multiple months or years. Going back to 1900, the lag time between an inversion and the beginning of a recession averaged about 22 months. However, in reviewing the last six recessions on the below FRED chart, the lag time ranged from 6 – 36 months (recessions are indicated by shaded gray areas on the chart).
line graph showing the treasury yield curve line graph showing the ten year treasury constant maturity minus two year treasury constant maturity
Portfolio implications/potential solutions to mitigate risks – Now that we know more about what is happening and possible impacts, what are some ways to potentially mitigate risk in your portfolio? At an asset classes level, starting with investment-grade bonds, the short-term outlook is not very positive because rising rates lead to lower bond values. This is especially true for longer dated bonds (10+ year maturities) as they are more sensitive to interest rate moves than shorter-term bonds. Given this, thought can be given to having more short-term bonds in your overall bond portfolio so that prices aren’t as sensitive to rising rates in this environment. Also, other asset classes that have tended to protect against inflation and/or rising rates include TIPS (Treasury Inflation-Protected Bonds), Floating-Rate Loans, Commodities, and Equities overall. However, there are many other risks and considerations with these asset classes, so protecting against inflation and rising rates cannot be the only factors considered if looking to invest in these areas. With all that being said, having a diversified and well-balanced portfolio from a risk perspective is still one of the most “tried and true” approaches overall. Let’s take a look at a fairly similar situation back in May 2004 – June 2006. During this time, the Fed hiked rates up to a 5% level and inflation was over 4.3% (not nearly as high as today yet was the highest level seen since the early 1990s at that point). Markets were volatile early on during this period, however, all returns ended up very positive with over 19%+ total return for each major equity index displayed on the chart. Lastly, the light green line on the bottom chart shows how a diversified 60% equity 40% bond portfolio performed. Not only did it keep up with the other major indices, but it also performed best during the early volatile periods where it did not fall as much yet recovered quickest. line graph showing the effective federal funds rate, u s inflation rate and total returns of the s and p 500, m s c i a c w i, Russell 2000, and a sample diversifed portfolio
Nobody knows exactly how things will turn out for markets and the global economy as the dust settles from the current environment we are in. Given that, taking a risk-managed, long-term approach and keeping your portfolio diversified has shown to be key in weathering the storm, reduce downside volatility, and putting yourself in the best position to succeed on the way back up.

Sources: YCharts, Sanctuary CIO Corner, Wall Street Journal, Goldman Sachs Global Investment Research, Goldman Sachs Investment Strategy Group, J.P. Morgan Asset Management, U.S. Bureau of Labor Statistics, Bloomberg, Federal Reserve Bank of St. Louis

Registered Representative of Sanctuary Securities Inc. and Investment Advisor Representative of Sanctuary Advisors, LLC. Securities offered through Sanctuary Securities, Inc., Member FINRA, SIPC. Advisory services offered through Sanctuary Advisors, LLC., a SEC Registered Investment Advisor. Tenet Wealth Partners is a DBA of Sanctuary Securities, Inc. and Sanctuary Advisors, LLC.

The information provided in this communication was sourced by Tenet Wealth Partners through public information and public channels and is in no way proprietary to Tenet Wealth Partners, nor is the information provided Tenet Wealth Partner’s position, recommendation or investment advice. This material is provided for informational/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Investments are subject to risk, including but not limited to market and interest rate fluctuations. Any performance data represents past performance which is no guarantee of future results. Prices/yields/figures mentioned herein are as of the date noted unless indicated otherwise. All figures subject to market fluctuation and change. Additional information available upon request. The “Sample Diversified Portfolio (60/40 Allocation) is comprised of the following total return indices and allocations: 40% S&P 500, 3% S&P 400, 4% S&P 600, 15% MSCI EAFE, 5% MSCI Emerging Markets, 40% Bloomberg US Aggregate Bond.