Central banks face an economic war on two fronts in 2022. Inflation is back, while growth has slowed following the post-Covid rebound. While investors can expect some tightening to occur, policymakers cannot allow real interest rates to rise too high, due to large overall debt levels, and will intervene if necessary. This should mitigate the risk of a fall in bond prices caused by rising yields, meaning fixed income investors should not be too bearish on duration.

Inflation is back (and here to stay)

While money supply growth has fallen from its early 2021 peak, it remains historically high. This is likely to continue to pass through to prices. A big difference between today and the period after 2008 is that, back then, money supply was continuously drained as banks parked liquidity back at the Federal Reserve to rebuild capital buffers. Today, bank balance sheets are relatively healthy, so Fed stimulus has added substantially to the stock of money. On a global basis, central bank liquidity has been the main driver for risk assets in the wake of the pandemic, with $17 trillion of credit created in 18 months.

Couple this with supply bottlenecks and the reining back of globalisation and conditions are ripe for inflation being less transitory than some have hoped.

Fed tapering could create near-term volatility

Rising inflation puts pressure on central banks to tighten policy. The Fed has hinted at plans for a quick taper of asset purchases by mid-2022 and indications are that rate hikes could begin in 2023, earlier than previously signalled. Alongside the Fed’s taper commitment, the US Treasury is expected to rebuild the reserves it holds in the Treasury General Account, which it has been running down since early 2021. This withdrawal of stimulus could create short-term volatility in bond markets, including rising Treasury yields and widening credit spreads.

Huge debt levels mean central banks need to keep rates low

Nonetheless, conditions are unlikely to tighten as sharply in 2022 as many fear. Even in the face of structural inflation, central banks will need to keep interest rates low for a protracted period, at least until the end of the decade. The reason is the scale of public and private debt, which combined hit a new record of $296 trillion in 2021 (more than 350 per cent of global GDP) according to the Institute of International Finance. Fighting inflation no matter the cost, as the Volcker-led Fed did 40 years ago, is simply not an option in 2022. Allowing refinancing costs to balloon would risk a spiral of defaults, depressing economic growth and making it harder still to service debt payments. Central banks will therefore need to ease off tightening if credit spreads widen too much, and duration risk should be less than if policymakers were free to normalise more aggressively.

Growth is also a concern

Central banks will also be keeping an eye on growth. Economies are past peak growth following the rebound from the pandemic, and continue to face supply bottlenecks and higher energy prices. There are reasons for optimism. The ‘Build Back Better’ agenda promises further fiscal stimulus in several countries, while bank lending, which has been relatively subdued since the early days of the pandemic, could pick up in 2022. Though this is dependent on vaccines holding the line against Covid-19 and the recovery continuing, albeit at a slower pace.

More capital could be directed to green growth

One consequence of increased bank lending could be more liquidity directed towards issuers with stronger sustainability credentials. Banks are under pressure to reduce the climate risk of their loan books. The European Banking Authority has said banks are already raising prices for and denying loan requests from some high-carbon emitters.

Fiscal support could follow a similar path. Major sovereign issuers like Germany and the UK have now entered the green bond market, issuing debt to fund sustainable infrastructure spending and other green activity. The green bond market is growing quickly but needs better standards, more liquidity, and competitive pricing to become mainstream. In the meantime, integrating sustainability considerations within an investment process can help identify issuers best placed to make the net zero transition.

A weaker dollar could boost emerging markets

Finally, we expect the dollar to track towards a longer-term weaker trend in 2022, which could be positive for emerging markets, despite some having to raise rates already in the face of higher inflation. The Fed may have struck a more hawkish tone in 2021 than both the European Central Bank and the People’s Bank of China, helping the dollar strengthen, but the twin budget and current account deficits remain a long-term drag on the US currency.

Income will matter more than capital appreciation

Against this backdrop, where can fixed income investors find returns in 2022? Credit spreads have little room to tighten further, which puts greater emphasis on coupons. A possible exception would be if market conditions caused spreads to widen, as happened with Asia high yield bonds in the wake of the Chinese company Evergrande’s debt crisis. This kind of scenario could create buying opportunities given central banks’ strong incentives to keep the system liquid.

If yield rises are capped, it will be important to focus on income and find assets trading at an attractive yield. That implies a bias to high yield bonds, where the default rate for US issuers has stayed below 1 per cent this year, although investors should not get too bearish on investment grade either. Nominal yields are likely to stay at or near current levels, despite inflation becoming more persistent than first thought, because real yields will have to be driven lower and lower to keep refinancing rates manageable.