We remain aware of the risks as the curve has flattened and credit spreads will likely increase from here. How bad it gets will depend on whether or not GDP growth is sustainable and can support higher long-term rates as the Fed continues on its tightening path. Further rate hikes amid a pick up in the reduction of the Fed’s balance sheet is a headwind to future economic expansion. Importantly, recent inflation data is likely to suggest to the Fed that they can escalate the pace of future rate hikes. If these hikes work to offset potential growth from expansionary fiscal policy, we would start to see the yield curve flattening trend continue and long rates move back down from their current levels.
In this market environment, we think investors should look towards variable rate bonds, preferred stocks as well as target an intermediate duration in their core fixed income allocations. Variable rate bonds can benefit as the Fed raises interest rates on the short-end of the curve. Meanwhile, without the threat of significantly higher long-term interest rates, preferred stocks can generate attractive current yield. Lastly, we think that intermediate duration bonds are attractive as the Fed raises short-term rates and the yield curve flattens.
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