With the volatility in markets in the wake of the collapse of Silicon Valley Bank (SVB) and other events, we have been asked by clients about our views on monetary policy and evolving views in bond portfolios. Here, we share a Q&A with Tim Ng, a portfolio manager in American Funds® Strategic Bond Fund and other rates-oriented strategies as well as a member of our fixed income interest rates team.

Given recent regional bank failures and the stress in the banking system more broadly, what is your overall view of the macro situation and monetary policy?

The collapse of Silicon Valley Bank reflected various factors. Many of these were arguably idiosyncratic, but there were also broader macro aspects that resulted from tighter financial conditions stemming from one of the U.S. Federal Reserve’s most aggressive hiking cycles in decades. We are also seeing some stress in Europe amid questions around Credit Suisse bank. The situation remains quite fluid but will likely result in even tighter financial conditions, particularly as bank lending slows and regulatory scrutiny increases. All else equal, I believe this will have a negative effect on economic growth, and the likelihood of recession has increased.

What does this mean for the Federal Reserve’s monetary policy, especially the path of interest rates?

The scope for the Fed to raise rates aggressively has narrowed dramatically with the recent developments in the banking sector. Only a couple of weeks ago, markets were pricing in more rate hikes and a higher terminal rate. I don’t expect the central bank to keep that pace. But I do think it will maintain a hawkish posture unless and until the economic outlook deteriorates materially. Inflation is still well above the Fed’s target and labor markets remain tight, as the latest economic data shows. The consumer is humming along. So looking at both sides of the picture, my expectation is that the Fed will temper its approach to rate hikes in the next few months and be more cautious. At the next meeting on March 22, I expect the central bank to raise the fed funds rate 25 basis points to a target range of 4.75% to 5.0%, and then assess the data and financial market conditions. In my view, there is a reasonable probability we will see a peak in the federal funds rate in the next few months.

Do you expect the Fed to cut rates later in the year?

I put a 50% probability on the Fed cutting rates in the second half of the year. The Fed is in an increasingly difficult position whereby inflation appears stubbornly high, but economic risks and challenges to financial market stability are rising. In my view, SVB is the first casualty of tighter monetary policy, and I believe others may follow as the Fed remains focused on curbing inflation.

How does this impact positioning in core and core plus bond portfolios?

We have been positioned for a steepening of the yield curve in several of our bond portfolios. This positioning has been additive given the market repricing we have seen with short-term Treasury yields rallying more than intermediate- and longer-term maturities. We still favor a yield curve steepener on the expectation that the Fed will eventually ease monetary policy as economic growth slows and inflation comes down. We have generally preferred yield curve steepeners over outright duration positions as we see greater return potential in yield curve positioning given how inverted the Treasury curve is by historical standards.

We have been relatively more cautious on credit in most core bond and core plus bond portfolios. Given the potential spillover effect from regional bank issues, we have seen some pressure on credit spreads, and this could continue, particularly if a recession becomes imminent. The bull case for credit markets is that the Fed eases and provides that support. But given its inflation mandate, and where inflation is today, the Fed is unlikely to support risk markets with monetary easing as quickly as it has in the past, which suggests a wider range of outcomes for spread products.