This article first appeared in Wealth, The Edge Malaysia Weekly on June 26, 2023 - July 2, 2023

The US Federal Reserve (Fed) paused its interest rate hikes this month. While further hikes down the road cannot be discounted, interest rates are likely to be peaking. Inflationary pressure is coming off, albeit at a slow pace.

The sharp rate hikes that started in February last year and culminated in the current level of 5.25% reached last month have already caused a mini banking crisis in the US. The pause will allow for a clearer picture to emerge over the second half of the year.

In this new normal of high inflation and high interest rates, there is a silver lining: fixed income assets are well positioned in terms of attractive yields. They also do well in a recessionary environment.

The mini crises seen in US regional banks such as Silicon Valley Bank (SVB) and First Republic Bank are an unintended result of stress in the US financial system, thanks partly to the rapid rate hikes.

The Fed took timely policy actions to manage the fallout. And it clearly stated that the fight against rising prices remains a key point of focus, together with its other objective of full employment.

However, the direction of inflation is rightly in line with what the Fed is happy to see. For example, the Consumer Price Index (CPI), a gauge of inflationary pressure, was +4% in June, in line with expectations. The CPI is expected to continue to fall over the course of 2023, although the Fed’s 2% inflation target is unlikely to be achieved this year.

Thus, a pause in the rate hike cycle will give the high interest rate time to impact the US economy. Historically, rising interest rates start to have an impact within six to 12 months.

Another unintended result of the mini banking crisis is the reduced lending activities of US regional banks. As a result of low investor confidence following the collapse of SVB, lending guidelines have been tightened and loan approvals have fallen as a result. This is being done to safeguard each individual bank’s liquidity position.

Banks have thus reduced their lending activities to avoid getting into liquidity problems. This tighter liquidity environment has the same effect on the US economy as rising interest rates. Thus, even without additional rate hikes, the US economy is likely to slow down in the months ahead.

With high interest rates and slowing growth, investors concerned about the US economy can look to fixed-income assets to supplement their equity portfolio. High-quality bonds or bond funds are well positioned in this environment of high and peaking interest rates.

First, the yields offered by these investment-grade bonds are at an attractive level of around 5%. With interest rates peaking, the worry among investors that bond prices will fall as bond yields rise is reduced. Most of the bond price corrections have already taken place.

Second, investors can rely on these blue-chip issuers to pay the interest on the bond papers, even if a recession hits the US.

At home, a peaking interest rate is also making Malaysian investment-grade (IG) bonds attractive. Bank Negara Malaysia last raised the overnight policy rate (OPR) to 3% last month.

Given that the OPR is now back to pre-pandemic levels and inflation is relatively well-behaved at just over 3%, a pause on interest rate hikes may be forthcoming on the local front as well. The current corporate IG bond yield is about 4.3%, according to an S&P Global Index of local corporate bonds.

For investors hunting for yield, local ringgit IG bonds are well equipped to weather the slowing growth in the US and provide attractive yields.

In this new economic reality, where bond yields are attractive again and growth is harder to come by, having an income strategy within one’s investment portfolio will ensure that your money is still working hard.

Michael Lai is executive director of wealth advisory (wealth management) at OCBC Bank (M) Bhd

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.