By Gertrude Chavez-Dreyfuss

NEW YORK, (Reuters) – Bond investors embrace safety as volatile markets take a huge hike from Federal Reserve after evidence of high inflation.

It appears that investors have dramatically changed their expectations regarding Wednesday’s decision. Instead of the expected 50 basis points, they now anticipate a rate hike at 75 basis points (bps). This increased hawkishness caused equity markets to tumble and bond yields to surge, temporarily inverting yield curve and pushing stocks into bear market.

Investors support faster Fed action to reduce inflation. However, they are concerned about the possibility of recession.

Nancy Tengler is chief executive officer, and chief investment officer of Laffer Tengler Investments, Scottsdale, Arizona.

“The real question is how the Fed acts. The Fed raising by 50, and saying they will consider 75, would mean that inflation is not in their sights. It is important to load up on the increases upfront.

Tengler claimed that the bond portfolios of her firm have been “defensive”, reducing the duration and improving the underlying value.

However, short-term debt tends to outperform longer-dated debt when there is a rise in interest rates.

Futures for the Fed funds Rate, which is the rate on overnight unsecured loans between banks and other institutions, currently reflect an 87% probability of a 75bps rate increase on Wednesday and 75% likelihood of another such rise in July. Markets have also included a fed funds rates of 4% for the summer 2019.

In comments posted on Twitter on Tuesday (NYSE:), Bill Ackman, Pershing Square Capital Management’s founder and chief executive, advocated multiple 75bps increases. He noted that the Fed must deliver on the expectations of the market if they are to restore market confidence. (Graphic: A sharp shift in Fed rate-hike expectations A sharp shift in Fed rate-hike expectations, https://graphics.reuters.com/USA-FED/gkplgkzwdvb/chart.png)

This year the Fed already increased rates by 75bps. Quantitative tightening is a method by which the Fed has begun to reduce its balance sheet. In its pandemic policy of accommodation, the Fed saw its balance sheet grow to $9 trillion.

Recent inflation spikes were a key catalyst for the change in expectations. Data showed last Friday that the U.S. Consumer Price Index (CPI), rose 8.6% in 12 months to May. This is the biggest year-on-year rise in nearly 40 years. (Graphic: Inflation, https://graphics.reuters.com/USA-STOCKS/myvmnrmenpr/inflation.png)

BOND MARKET BETS

Short-term bets were made by fixed income players ahead of the Fed decision.

Some traders have decreased short-maturity trades because they believe there are potential opportunities on the market, given credit spreads that have widening and the rise in rates since the beginning.

Although we are now experiencing shorter duration, it is still a significant amount. R.J. Gallo is senior portfolio manager for Federated Hermes (NYSE :). He said that we have been increasing the quality and quantity of our portfolios in the belief that tighter monetary policies and choppier markets should result in credit spreads expanding.”

The Treasuries are slightly over-weighted in the portfolios of his son. “We like the quality Treasuries that can be used to defend,” says he.

Yet, despite Fed’s tightening of the economy, many bond investors are seeing opportunities in fixed income and it could be time for them to abandon safety bets.

Jason Brady, Chief Executive Officer at Thornburg Investment Management, Santa Fe, New Mexico overseeing assets totalling $46 billion, stated that “at this point, it is not the best place to be incredibly conservative both from a credit- and duration standpoint”

“That was where we were, and that’s what we want to leave.”

Brady believes his firm is marginally less conservative when it comes to credit spread.

Brady pointed out U.S. High Yield Debt, which had a spread to Treasuries increasing to 487 basispoints on Monday. He noted that investors would get a greater than 7% yield if they invested in U.S. Five-year Treasuries at 3.5%.

David Petrosinelli is the managing director of broker-dealer InspereX New York. He has been encouraging investors to take a defensive approach with bond portfolios, starting in the fourth quarter last year. However, he still thinks the Fed might slow down the pace of tightening in the second half of this year.

A barbell strategy is a combination of short- and long-term bonds. Investors will be able to invest the short-term securities’ proceeds at a higher rate if rates rise.

Petrosinelli is convinced that the Fed’s aggressive increases this year will cause a drastic drop in consumption before end-2022.

The Fed will slow down its rate hikes in the fourth quarter due to this. Although they’ll still have to raise rates, the pace of increases will be decreasing quickly.