Investors today face a significant amount of uncertainty over whether now is a good time to buy bonds given the risk of further central bank rate hikes. Some data shows that actual economic performance remains strong, while other data shows economic activity may contract at some point in the future. This divergence in data creates a very challenging forecasting environment for investment professionals and an even harder one for investors.

With this challenging environment in mind, Alexandra Gorewicz, CIM, Portfolio Manager, Active Fixed Income, TD Asset Management Inc. (TDAM) recently authored an article titled Global interest rates - From "lower for longer" to "higher for longer" and (eventually) back again? The article discusses key issues investors face today including, if we will ever get back to target inflation, new obstacles including the Silicon Valley Bank (SVB) failure, Credit Suisse events and the significance of a new rate floor.

While the article is stacked with great insights, of particular interest is the section that discusses Fed policy rate scenarios. Here, Alexandra outlines 4 different scenarios (and assumptions) for Fed policy rate paths.

Scenario 1 - a soft landing: Here we assume the Fed's December-2022 economic projections are realized such that they hike to a peak rate of 5.25% this year, which gradually begins to fall next year until it reaches a long-run rate of 2.5%.

Scenario 2 – no landing: We assume that the Fed's inflation forecast for the end of 2023, which is 3.5%, becomes sticky. That is, the bulk of the easy disinflation gains occur through 2023, but due to the overwhelming macroeconomic challenges in a geopolitically fragmented world, inflation cannot fall below 3.5%. Here, we assume the Fed initially hikes the policy rate to 7%, but, in time, accepts 3.5% as its new inflation target and normalizes the policy rate to 4% (just above its new 3.5% inflation target.)

Scenario 3 – hard landing: Something breaks in the economy, in a big way. The Fed pauses at its current rate of 5% because unemployment begins to rise very quickly. As the economic contraction gains momentum and inflation falls off a cliff, the Fed begins to cut the policy rate in the fourth quarter of 2023 and ultimately cuts to 0% by 2025. Eventually, the policy rate gradually moves back up to 2%.

Scenario 4 – new inflation shock: We assume a new shock takes inflation back above 8% and the Fed hikes to a peak rate of 10% by early 2024. In time, the policy rate is lowered to 5%, which is the highest long run policy rate in all scenarios.

While we attribute higher probabilities to Scenarios 1 and 2, all four scenarios help shape our outlook for interest rates in 2023. And whether we only consider Scenarios 1 and 2 or we look at all four scenarios together, we expect a positive skew in expected returns for interest rates this year. In the face of so much uncertainty, this opportunity in government bonds is as compelling as it possibly can be.

Remember to check out the full article located on our insights page.

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