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By Jim CaronCo-Lead Global Portfolio Manager, Co-Chief Investment Officer, Global Balanced Risk Control

New York - As interest rates have risen, many investors have found a "safe harbor" in owning shorter-duration fixed income assets. Shorter-duration bond prices fell less when interest rates rose, compared to longer-duration bonds whose prices are much more sensitive to interest rate moves. While we agree that a shorter duration strategy can be productive when rates are rising, we believe investors need to find efficient and diversified ways to express this view.

Many investors may think that simply owning U.S. two-year Treasury Notes (US2Y) is the answer, but they are also justifiably worried about holding a position for two years in this environment. We think there is a better way.

Current market conditions

Let's look at current market conditions for some context. Bond yields have fallen due to a larger-than-expected decline in October's Consumer Price Index (CPI) inflation data. This catalyzed a view that the Federal Reserve may not need to hike interest rates as high as previously thought, and made the US2Y attractive.

But we see it differently. We think would-be purchasers of US2Y should be wary of the risk that the Fed may be compelled to hike rates even higher than expected, which would hurt the asset's performance. Some explanation is warranted.

We start with a simple question: Is the Fed satisfied or worried about the recent sharp decline in inflation data? It is our view that yes, the Fed is satisfied that inflation is falling — but also worried that risky assets staged a historic rally as a result.

The rise in equity prices, fall in the U.S. dollar and tightening of credit spreads all functioned to ease financial conditions. However, they also served to increase longer-term inflation risks, working against what the Fed is trying to accomplish. In fact, that may have set the stage for the Fed to hike rates even higher than expected, as the recent rally in financial assets provides them with a cushion to do so.

Following the CPI release, a chorus of Fed officials unequivocally informed the market that they still have a lot more work to do, in that inflation has not yet been contained. The Fed may hike another 100-125 basis points (bps) between now and the end of 1Q 2023 — when policy rates would reach the 5% to 5.25% range — and then hold there for an extended period of time.

Furthermore, stronger-than-consensus Retail Sales data have indicated that real consumption remains robust and puts 4Q 2022 GDP on track for a sharp rebound. That could throw a wrench at the Fed's plan to lower inflation by curtailing demand!

Alternatives to holding US2Y

In this plausible scenario, we could see US2Y performance become stressed. That makes us wonder, instead of investing at only one point on the front end of the yield curve, why not express a view to own short-duration assets in a more diversified way?

Short-duration government income, ultra-short-duration money markets and even short-duration municipal bond ladders should be considered as a complement — or an outright substitute — to an otherwise undiversified view of owning only US2Y.

Bottom line: The key is that these other strategies may also offer more liquidity to investors who are justifiably worried about holding a position for two years.