U.S. Treasury yields started the year with a sharp move higher as investors confront the possibility that the U.S. Federal Reserve may not only embark on an accelerated rate-hiking cycle, but also bring forward the timetable to begin reducing the size of its balance sheet.

With the Fed and other central banks gearing up to tighten monetary policy to combat persistent signs of inflation, just as the spread of the omicron variant of COVID-19 produces fresh economic disruptions, we expect financial markets to experience further volatility during the first quarter of 2022.

Given the advancing stage in this economic cycle, and the market’s heightened sensitivity to incoming data as the Fed prepares to withdraw stimulus, PIMCO advocates a nimble approach and prefers investments at the higher end of the liquidity spectrum. We also favor being underweight duration, or market exposure to U.S. interest rates.

Central banks take center stage

U.S. 10-year yields rose to the highest level in two years to start 2022, climbing as high as about 1.79% from 1.51% at the end of 2021. The yield curve, which represents the difference between shorter- and longer-dated bond yields, flattened as investors pulled forward expectations for the Fed and other central banks to increase short-end policy rates.

The moves came as the Fed last week released minutes from its December policy meeting that further highlighted the central bank’s recent hawkish turn in the face of economic data showing continued strength in inflation and wage growth.

At that meeting, officials brought forward their forecasts for rate hikes, with the median projection showing three increases in 2022, three more in 2023, and two in 2024. The Fed also doubled the pace of tapering its asset-purchase program, which is on track to end by mid-March.

Other major central banks have recently changed course as well. The Bank of England in December unexpectedly raised its policy rate, to 0.25% from 0.10%, to combat persistent inflationary risks, while the European Central Bank said it would scale back its own asset-purchase program.

The minutes showed the Fed also discussed a timetable to potentially start its balance-sheet runoff. That’s when the Fed will no longer reinvest proceeds from maturing Treasury and mortgage-backed securities it has bought as part of its quantitative easing (QE) program. The minutes indicated officials are focused on inflationary risks and view the labor market as closing in on levels the Fed considers maximum employment.

Outlook calls for volatility

The latest monthly U.S. employment data, released last week, offered further evidence of the forces that may accelerate policy tightening. The report showed strong hourly earnings and an unemployment rate that fell to just 3.9%, figures that seem to support the likelihood of an initial Fed rate hike in March. In that event, a balance-sheet-reduction announcement could come as early as midyear, in our view.

Data this week showed the consumer price index rose 7% year-over-year in December, the fastest annual pace in almost 40 years. This came broadly in-line with economists’ forecasts and market expectations. U.S. 10-year Treasury yields retreated modestly after the report.

The prospect of rising rates and central bank bond-buying programs moving into reverse – known as quantitative tightening, or QT – is being felt across financial markets. The breakeven rate for Treasury Inflation-Protected Securities (TIPS), which measures the difference between nominal and inflation-adjusted yields, fell late last week amid concerns about potential QT and increased TIPS issuance set for 2022.

Despite the possibility of heightened volatility, we believe 2022 can provide an attractive opportunity set for investors positioned to take advantage of both macro and relative value opportunities when they arise. We also expect active duration management to become a more important factor in investment returns than in the past.

For more on interest rates, visit PIMCO’s rates page.

Rick Chan is a portfolio manager focusing on global macro strategies and relative value trading in interest rates.Abhishek Nadamani is a portfolio manager on the U.S. rates desk.Christopher Youssef is a portfolio manager focusing on interest rate relative value trading strategies.