Wider credit spreads and higher 2-year UST yields are signaling that investors should position for the beginning of the rate hiking cycle. Future returns will likely come from alpha, rather than from spread compression, in the year ahead.

Credit spread and 2-year UST yield
Option adjusted spread, market yield on U.S. Treasury securities at 2-year constant maturity

Line graph showing option adjusted spread, market yield on U.S. Treasury securities at 2-year constant maturity

Source: St. Louis Fred, Barclays POINT, Principal Global Investors. Data as of December 15, 2021.

The attention of fixed income investors has quickly shifted in the latter portion of 2021, as stubbornly high inflation prints have forced the U.S. Federal Reserve (Fed) to, at last, publicly acknowledge that inflation may not be transitory. Not only did the Fed announce a doubling in the pace of asset purchase reductions at December's Federal Open Market Committee (FOMC) meeting, but it also signaled that they're likely to raise interest rates multiple times in 2022. Investors have taken notice of the rhetoric, and in recent weeks have pushed 2-year U.S. Treasury (UST) yields and investment grade (IG) spreads up quite quickly.

As markets approach rate lift off in 2022, expect both the flattening of the UST yield curve and increasing credit spread volatility to continue. In aggregate, improving credit fundamentals should also persist, as above-trend GDP growth is broadly supportive for the credit metrics of IG bond issuers.

How can investors prepare for this rate hiking cycle? The rise in 2-year UST yields is signaling tighter liquidity as tapering ends and rates lift off, which will likely keep fixed income volatility elevated and credit spreads wide. In this environment, positioning fixed income portfolios to earn returns from alpha rather than from spread compression or duration will be key.

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