Fed funds rate will reach 4.25% and here are what bonds to buy, Wells Fargo Institute says

Sep. 20, 2022 1:48 PM ETLQD, BLV, BSV, HYG, MUB, JNK, VCSH, VCLT, FLOT, FLRN, VTEB, IGSBBy: Jerry Kronenberg, SA News Editor95 Comments

Fed Rate Hike Ahead Warning Sign

JimVallee

The Federal Reserve will keep tightening until the fed funds rate hits about 4.25%, while the yield curve will stay inverted longer than usual and America will enter recession in 2023’s first half, the Wells Fargo Investment Institute predicts.

“With a little over 100 days until the end of the year, investors are bracing for a bumpy ride. The U.S. economy is still facing threats from elevated inflation (as evidenced by last week’s Consumer Price Index report for August), coupled with a slowdown in economic activity,” the Wells Fargo unit wrote in its latest weekly strategy note.

The firm predicts the Federal Open Market Committee will fight inflation by raising the fed funds rate by 75 basis points at this week’s monetary-policy meeting, followed by smaller hikes for the next three to four FOMC sessions.

All told, the Wells Fargo analysts predict the benchmark rate will peak at around 4.25% from today’s 2.25%-2.5% range, “but the bias on all our forecasts remains to the upside should inflation levels remain elevated.”

As for what that means for bond investors, Wells Fargo’s Luis Alvarado wrote that he favors:

  • A “Barbell” Fixed-Income Strategy. This involves investing in a mix of short- and long-maturity bonds, as Alvarado expects short-term rates to continue rising but longer-term yields to soon peak.
  • Investment-Grade Bonds Over Junk Ones. The analyst touted high-quality, investment-grade corporate bonds rather than high-yield taxable ones, writing that “the main threat for [high-yield bonds] likely will come from further monetary tightening and the deterioration in credit conditions as economic growth slows.”
  • Munis. Alvarado favors municipal bonds due to their relatively low default rates, coupled with “positive technical trends due to the supply-demand imbalance and improved fiscal positions after the pandemic.”
  • Floating-Rate Bonds. The analyst wrote that assets like leveraged loans typically outperform other fixed-income classes in rising-rate environments.
  • Caution on Preferred and Emerging-Market Debt. Alvarado recommended a neutral allocation for preferred stock and emerging-market bonds.

The analyst didn’t recommend any specific bond portfolios, but popular fixed-income ETFs in terms of assets under management include:

  • Short Maturity. Vanguard Short-Term Bond ETF (BSV), Vanguard Short-Term Corporate Bond ETF (VCSH)
  • Long Maturity. Vanguard Long-Term Corporate Bond ETF (VCLT), Vanguard Long-Term Bond ETF (BLV)
  • Investment Grade. iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB)
  • High Yield. iShares iBoxx $ High Yield Corporate Bond ETF (HYG), SPDR Bloomberg High Yield Bond ETF (JNK)
  • Munis. iShares National Muni Bond ETF (MUB), Vanguard Tax-Exempt Bond ETF (VTEB)
  • Floating Rate. iShares Floating Rate Bond ETF (FLOT), SPDR Bloomberg Investment Grade Floating Rate ETF (FLRN)

As for stocks, Seeking Alpha contributor Mott Capital argues that equities could rally after this week's FOMC meeting regardless of what the Fed does with rates.

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