The January FOMC meeting confirmed the hawkish shift telegraphed by FOMC members in recent weeks. The Federal Open Market Committee (FOMC) voted to maintain the current Federal funds target rate at a range of 0.00%–0.25% and reaffirmed its current plans to taper its asset purchases to zero by early March. Given persistent elevated inflation and falling unemployment, the committee now expects it will “soon” be appropriate to raise the Fed funds rate, paving the way for the first rate hike at its March meeting. 

The meeting was overall viewed as hawkish from the markets. At the press conference, Chairman Powell stressed that because the economy is in a very different place then when the committee began hiking in 2015, the magnitude and pace of rate hikes are still uncertain. To some extent, this leaves the door open for a potential 50 basis point increase or more hikes than current expectations. Bond yields jumped and equities sold off as a result.

Elsewhere, the committee seems prepared to begin reducing the size of its ballooned balance sheet, potentially sometime later this year. We dive into our outlook and potential implications of this policy tightening here. Altogether, even with the sizable move higher in rates already this year, the Fed outlook points to even higher yields in 2022. With this backdrop, investors may consider abandoning fixed income altogether, but they should be reminded the critical role fixed income still plays in portfolios. 

As outlined below, our framework for fixed income diversification can help investors seek to generate income and reduce overall portfolio volatility. A few key points:

• Fixed income continues to play a critical role in portfolios for diversification to equities, downside protection and income generation
• The fixed income triangle is a framework to help investors properly diversify their fixed income allocations
• Depending on your client’s investment goals and expectations of rising rates, the triangle suggests how much to allocate to different style fixed income strategies to properly diversify risks and position for rising rates

Even with a more hawkish Fed, risks to the outlook remain: a more pronounced slowdown in China, escalating geopolitical tensions, and heightened market volatility are likely to cause some choppiness in markets, keeping the Fed flexible in its path towards tighter policy. Fixed income can still play defense during periods of market turbulence and investors would be wise to maintain exposure through a more active approach as rates grind higher.  

Fixed Income Triangle: A strategic framework for diversification

Shown for illustrative purposes only. Because everyone’s circumstances are unique, this model can provide a framework for discussion between you and your financial professional.

Diversification does not guarantee investment returns and does not eliminate the risk of loss. Investments in fixed income securities are subject to interest rate risk. If rates increase, the value of the investment generally declines. Lowering a portfolio’s volatility can, in and of itself, improve returns. Mathematically, when comparing two portfolios with the same average annual return, the portfolio with the lower volatility (i.e., the portfolio where each year’s returns are generally closer to the average) will have higher compounded returns over time. The larger the swings in compounded return, the lower the total return over time.

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