By: Steven L. Yamshon, Ph.D., Managing Principal
The Federal Reserve (the “Fed”) bank knows that there is too much liquidity in the system but has mixed feelings about reducing it. My sense is that the Fed will need to see that the following five factors are in place before they do anything:
All of the above factors have been accelerating, which leads me to believe that the Federal Reserve will start to first taper excess liquidity, and then begin to raise interest rates by the end of 2022.
If the Fed liftoff occurs as planned and unforeseen circumstances do not occur, we expect the 10-year Treasury bond to level off around 2% to 2.25%. To us, the message is clear, in an environment of rising interest rates, new buyers of bonds need to keep their duration shorter than benchmark duration. If the Federal Open Market Committee (“FOMC”) follows through with increases in interest rates, monetary policy will not become extremely tight until 2024. It is too soon to guess about the pace of tapering and the rise in interest rates, but the big move in financial markets will likely occur when interest rates rise above the equilibrium rate. We are not there yet.
If monetary policy will not be restrictive for approximately three years, we believe it is too premature to shift to a defensive position, especially if investors share our view that risk assets should perform well over the next 12-months.
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