The past months have delivered a sharp U-turn in market rate expectations. Ralph Gasser, Head of Fixed Income Investment Specialists, shares his views on recent developments and explores these shifts and their implications on investment opportunities across fixed income markets.
19 September 2024
Inflation and growth indicators have been cooling and increasingly surprising to the downside over recent months, led in the western world by the US. The market reaction to this has certainly been pronounced, with consensus rates expectation shifting to rate cuts of at least 25 basis points in each of the Federal Reserve’s (Fed) next seven meetings – including this Wednesday’s meeting – with the mid-Fed Funds Rate set to end 2025 at around 2.75% to 3.00%.
The Fed initiated its rate cutting cycle on Wednesday 18 September with an aggressive 50 basis points, while at the same time tempering market expectations somewhat, highlighting the overall healthy state of the of the US economy. One could certainly also argue that this 50 basis point move incorporates a missed 25 basis points cut opportunity at its July meeting. Fed officials now expect the policy rate to drop to 4.4% by the end of 2024 and to 3.4% by the end of 2025.
Chart 1: Markets priced for hefty cuts
Source: Bloomberg, GAM, Data as of close of trading 18-Sep-24. Total cuts in chart on the right refer to change versus month-end Aug-24 interest rate levels.
While I certainly subscribe to these trend forecasts, market-implied level assumptions look ambitious. Yes, the US economy is slowing but it is by no means tanking and should be able to maintain a very reasonable real GDP growth rate around 1.5% to 2.0% in 2025 and 2026, in my view. Also, cyclical inflation is more likely to stay a fair bit above the 2% target for some time to come, with potential upside risk from a new US administration’s policies on trade tariffs, price interventions or taxes, to name just a few. Against this backdrop, one would see a “neutral” policy rate closer to 3.5% or higher, not below 3%, as is being priced for.
Looking further out the yield curve, the US annual budget deficit is already set to run at above 6% over the next several years, independent of who will take the seat in the White House, and current policy proposals put forward by both presidential candidates could easily add another 1-2% to his already unsustainable number. At the same time, the Fed is committed to further shrink its QE-related securities holdings, which in combination with inflation upside risks may provide upside pressure on spreads at the longer end of the yield curve. 1-year forward rates for maturities of three years or longer already price at or above current spot rates. If current forward pricing were correct, 10-year US Treasuries would deliver a total return of only about 2.6% and 10-year German Bunds just about 2.3%. Considering the shape of the yield curve and roll-down effects, shorter end duration with below 5-year maturities should be a better place both in the US and in Europe.
With the short-term yield gap between the US and the rest of the world set to narrow materially from here irrespective of ultimate exact rate levels, this should deliver a somewhat softer US dollar and reduced US dollar hedge costs. This should, in my view, be underpinned by the fact that in real effective exchange rate terms, the US dollar still trades expensively relative to most western and emerging market currencies, even in light of recent corrections.
Chart 2: Time for a weaker US Dollar?
Source: Bloomberg, GAM, Data as of close of trading 18-Sep-24.
In combination with a still substantial excess carry over US Treasuries of more than 3.5% and relatively cheap local rates across positively shaped curves, this should make strategies such as local emerging market debt a main beneficiary, notwithstanding a possible pick-up in volatility depending on the outcome of the US election.
While rates and currency markets have shifted materially over recent months, credit markets have not. Corporate credit risk remains extremely tightly priced, be it against implied 12-month forward credit risk, relative to historic spread-to-credit-cost multiples, compared to the economic cycle or against broader implied market volatility.
But one can certainly still find value outside of the heavily populated corporate credit space. For instance, spreads for shorter-end duration non-agency mortgage-backed securities (MBS) are still trading above pre-Covid-19 levels, as opposed to corporates. Emerging markets sovereign spreads look modestly cheap overall but offer substantial value to selectors at the single country, bottom-up level. The most glaring spread pick-up, however, currently shows up in catastrophe (cat) bonds, where a mismatch of cyclical and tactical supply and demand keeps spreads near record highs, both in absolute, relative and risk-adjusted terms, in turn offering compelling value over like-for-like corporate credit risk, as illustrated in Chart 3.
Chart 3: Material value outside heavily populated areas – Example Cat bonds
Source: Bloomberg, BofA, GAM. Data as of 31-Aug-24. Cat bond reference portfolio is (a) fully invested; (b) publicly listed bonds; (c) focus on “peak perils”; (d) focus on natural disaster risk, mostly US-related. 1-3 year US corporate bond sub-indices spreads used to best match cat bond maturity and duration profile. Average spread of 1-3 year US corporate sub-indices based on corresponding month-end ratings of cat bonds reference portfolio*. Cat bond implied ratings based on expected loss. Cat bonds reference portfolio* bond multiple is calculated as follows: Average Portfolio Spread / 12-month Expected Loss. Equally ratings weighted 1-3 year US corporate bond multiple is calculated as follows: Average Spread / (12-month Default Rate – 12-month Recovery Rate-adjusted Loss Rate).
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The Consumer Price Index (CPI) measures the monthly change in prices paid by US consumers. The Bureau of Labor Statistics (BLS) calculates the CPI as a weighted average of prices for a basket of goods and services representative of aggregate US consumer spending. The US Dollar Index is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of US trade partners' currencies. The Index goes up when the US dollar gains "strength" (value) when compared to other currencies. References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index or benchmark.
The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the markets generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.
The Consumer Price Index (CPI) measures the monthly change in prices paid by US consumers. The Bureau of Labor Statistics (BLS) calculates the CPI as a weighted average of prices for a basket of goods and services representative of aggregate US consumer spending. The US Dollar Index is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of US trade partners' currencies. The Index goes up when the US dollar gains "strength" (value) when compared to other currencies. References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index or benchmark.
The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the markets generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.