2022’s High Conviction Trade: Rising Rates
Published January 4, 2022
Kevin Flanagan
Head of Investment and Fixed Income Strategy
In 2021, our primary theme was the reflation trade, which obviously turned into the inflation trade when the ‘whites of the eyes’ of inflation could first be seen back in May. The next step in this investment process is increasingly apparent. The natural next stage in this evolution means rising rates are becoming our primary investment theme for 2022.
It is interesting to note that Treasury (UST) yields have already begun to step into their leading role, with rates all along the fixed coupon yield curve residing at levels visibly above where they stood a year ago, and in some cases, just months ago. Let’s take a look at three of the more closely watched Treasury maturities and compare where their yields are as of this writing versus New Year’s Day 2021:
- UST 2-Year yield is up 55 basis points (bps)
- UST 5-Year yield is up 86 bps
- UST 10-Year yield is up 55 bps1
If you look closely, you’ll see that, although yields have increased rather noticeably, the Treasury yield curve, as measured by 2s versus 10s, has actually remained the same. In other words, after a sawtooth pattern to the upside for the UST 10-Year yield, the UST 2-Year note has now caught up and registered an identical rate increase over the last 12 months. The increase of nearly 90 bps in the UST 5-Year note definitely stands out and underscores the reason why rates are poised to move higher from their current levels.
The increase in Treasury yields last year occurred essentially without any assistance from the Fed. Sure the policy makers started tapering their large-scale asset purchases, but that wasn’t until November. Even at the December FOMC meeting, when the policy makers announced a quicker end to their tapering process along with a ‘dot plot’ looking for three rate hikes this year, this result was widely expected. In fact, if you think about it, rates rose with the Fed barely raising a finger in the process.
That is where the key, and arguably most important, part of the 2022 rising rate trade comes into play—namely, the Fed will now be joining the party. So, investors begin this process with the consensus call now looking for three rate hikes this year. The policy makers will be very data-dependent on this front, and if you believe, like we do, that inflation will remain stubbornly high, you may want to take the ‘over’ on those three rate hikes, not the ‘under.’ At this point, I believe Powell & Co. will maintain a deliberate approach, but that could change based on future inflation numbers.
Conclusion
Based on our rate outlook, here are three rate hedge solutions to consider:
- UST-based: WisdomTree Floating Rate Treasury Fund (USFR) versus short-term fixed coupon Treasuries and TIPS. UST 1–3-Year yields are susceptible to Fed rate hikes, while 10-Year TIPS, or real yields, are not immune to periods of rising rates either.
- Investment Grade: WisdomTree Interest Rate Hedged U.S. Aggregate Bond Fund (AGZD) versus corporate floating rate vehicles. Higher yield, with more diversification (representative of the Bloomberg U.S. Aggregate Bond Index) and less concentration in the financial sector.
- Core Plus: WisdomTree Interest Rate Hedged High Yield Bond Fund (HYZD) versus bank loans. A quality screen that tilts for income and targets zero duration.
1 Source: St. Louis Fed, as of 12/22/21
Important Risks Related to this Article
USFR: There are risks associated with investing, including the possible loss of principal. Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but may decline in value. The issuance of floating rate notes by the U.S. Treasury is new and the amount of supply will be limited. Fixed income securities will normally decline in value as interest rates rise. The value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Due to the investment strategy of this Fund it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
AGZD: There are risks associated with investing, including the possible loss of principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. The Fund seeks to mitigate interest rate risk by taking short positions in U.S. Treasuries (or futures providing exposure to U.S. Treasuries), but there is no guarantee this will be achieved. Derivative investments can be volatile and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions.
Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. The Fund may engage in “short sale” transactions of U.S. Treasuries where losses may be exaggerated, potentially losing more money than the actual cost of the investment and the third party to the short sale may fail to honor its contract terms, causing a loss to the Fund. While the Fund attempts to limit credit and counterparty exposure, the value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
HYZD: There are risks associated with investing, including the possible loss of principal. High-yield or “junk” bonds have lower credit ratings and involve a greater risk to principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. The Fund seeks to mitigate interest rate risk by taking short positions in U.S. Treasuries (or futures providing exposure to U.S. Treasuries), but there is no guarantee this will be achieved. Derivative investments can be volatile and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions.
Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. The Fund may engage in “short sale” transactions where losses may be exaggerated, potentially losing more money than the actual cost of the investment and the third party to the short sale may fail to honor its contract terms, causing a loss to the Fund. While the Fund attempts to limit credit and counterparty exposure, the value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.
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About the contributor
Kevin Flanagan
Head of Investment and Fixed Income Strategy
Kevin serves as the Head of Investment and Fixed Income Strategy. In this role, he writes macro and fixed income-related content and works closely with the sales, research and marketing teams. In addition, Kevin conducts client-facing webinars and meetings, providing expertise on WisdomTree’s existing and future bond ETFs. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was Managing Director and Chief Fixed Income Strategist for Wealth Management. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S. in Finance from Fairfield University.