Positioning bond investments for steep rate cuts
Positioning bond investments for steep rate cuts
Ariel Bezalel and Harry Richards say that the state of the global economy calls for a sharp decline in interest rates in the coming months, which could potentially benefit government bonds.
The fixed income markets have sharply repriced over the past few months, as investors believe cooling inflation and rising unemployment could prompt a series of interest rate cuts in the next two years.
The US Federal Reserve (Fed) has already kicked off its easing cycle by cutting rates by 50 basis points, joining other major central banks that have been grappling with sluggish growth. The move was spurred by macroeconomic data published during the Summer, which have clearly shifted the balance of risks for monetary policy from the price stability side of the Fed’s mandate to full employment.
Fed Chair Jerome Powell has said the Federal Open Market Committee (FOMC) does not “seek or welcome further cooling in labour market conditions”, which underscores the importance the central bank attaches to the jobs data.
The unemployment rate has shown a material increase in the last 12 months. While the absolute level remains benign and not too far from what could be defined as maximum employment, the speed of increase in unemployment looks worrying and historically this has been a very good predicator of US recessions (as demonstrated by the widely discussed Sahm rule).
The US Federal Reserve (Fed) has already kicked off its easing cycle by cutting rates by 50 basis points, joining other major central banks that have been grappling with sluggish growth. The move was spurred by macroeconomic data published during the Summer, which have clearly shifted the balance of risks for monetary policy from the price stability side of the Fed’s mandate to full employment.
Fed Chair Jerome Powell has said the Federal Open Market Committee (FOMC) does not “seek or welcome further cooling in labour market conditions”, which underscores the importance the central bank attaches to the jobs data.
The unemployment rate has shown a material increase in the last 12 months. While the absolute level remains benign and not too far from what could be defined as maximum employment, the speed of increase in unemployment looks worrying and historically this has been a very good predicator of US recessions (as demonstrated by the widely discussed Sahm rule).
US Unemployment Rate Sahm Rule* vs. US Recessions
Source: Bloomberg as at 30.09.24
Non-farm payrolls and US Consumer Price Index (CPI) data are the two important data that have been published since the rate cut. Some say the strong payroll numbers in September, which exceeded expectations, point to a robust economy. But we aren’t convinced by the quality of job creation as the rise was mainly driven by non-cyclical jobs (government, healthcare and private education). The cyclical component of payrolls shows a much more anaemic growth in the last couple of quarters:
Private payrolls ex-Education & Health services – Contribution to total US Payroll growth in the past 12 months
Private payrolls ex-Education & Health services – 6m growth
Source: Bloomberg as at 30.09.24
US consumers are in a weak position too. More recent estimates show the excess savings accumulated during the pandemic have been completely depleted. In other words, the additional fuel for US consumption has been exhausted. Credit quality for consumers continues to weaken with delinquencies across consumer loans showing a sharp increase in the last couple of quarters.
US real excess savings by income quartile
Source: Bloomberg as at 30.09.24
Non-farm payrolls and US Consumer Price Index (CPI) data are the two important data that have been published since the rate cut. Some say the strong payroll numbers in September, which exceeded expectations, point to a robust economy. But we aren’t convinced by the quality of job creation as the rise was mainly driven by non-cyclical jobs (government, healthcare and private education). The cyclical component of payrolls shows a much more anaemic growth in the last couple of quarters:
US economy holds the key
US elections add the usual uncertainty to the picture, but the space for additional stimulative fiscal spending, at least in 2025, looks fairly limited, especially with the interest burden taking an increasing share of the deficit. The United States have been driving global economic growth across developed markets for quite some time now. Hence, we’ll be closely watching the economy for any turning point.
The rest of the world continues to look in a precarious position to us. The recovery in the Eurozone has almost faded, with recent Purchasing Managers Index (PMI) readings showing renewed weakness. This does not look surprising. Before the pandemic, the Eurozone economy showed various signs of structural weakness, related to weak demographics and lack of competitiveness. These issues persist, and together with strong competition from China, act as a headwind for the manufacturing sector.
The UK economy surprised to the upside in the first half, but more recent data have shown some deterioration. Limited room for additional fiscal spending and rapid repricing in rates on outstanding mortgages represent key drags on the economy. Australia recorded its weakest GDP reading of the last three decades in 2Q with the exception of the Covid period. Growth in New Zealand is already in negative territory. While equity markets have been cheering the new easing cycle in China, we would argue this is a strong signal of the structural weakness in the Chinese economy.
The rest of the world continues to look in a precarious position to us. The recovery in the Eurozone has almost faded, with recent Purchasing Managers Index (PMI) readings showing renewed weakness. This does not look surprising. Before the pandemic, the Eurozone economy showed various signs of structural weakness, related to weak demographics and lack of competitiveness. These issues persist, and together with strong competition from China, act as a headwind for the manufacturing sector.
The UK economy surprised to the upside in the first half, but more recent data have shown some deterioration. Limited room for additional fiscal spending and rapid repricing in rates on outstanding mortgages represent key drags on the economy. Australia recorded its weakest GDP reading of the last three decades in 2Q with the exception of the Covid period. Growth in New Zealand is already in negative territory. While equity markets have been cheering the new easing cycle in China, we would argue this is a strong signal of the structural weakness in the Chinese economy.
Value in government bonds
Inflation across the globe increasingly seems less of a problem and the widely discussed lags in service inflation still leave very meaningful room for disinflation in the coming months. We continue to see monetary policy across major developed markets as too restrictive, especially the current level of real rates. The key implication is that monetary policy has a lot of room to cover just to get back to neutral. Market expectations recognize this and have priced a return to that neutral level (or close by) in the coming two years. In our view this does not price yet the risk of a more material slowdown and perhaps a recession that could force central banks to go beyond neutral as typically happens during a cutting cycle.
Given the above, notwithstanding the recent rally, we continue to see value in government bonds across developed markets. Besides the US, the UK and Australia look increasingly attractive.
Corporate credit continues to look expensive, and the spreads are near all-time tights. As always, it is very hard to exactly time the moment of a spread widening. As such, given our long duration bias we still prefer to include some credit exposure across our portfolios as a diversifier and source of carry if a more benign environment for growth were to unfold. Within such credit exposure we are however very selective.
Given the above, notwithstanding the recent rally, we continue to see value in government bonds across developed markets. Besides the US, the UK and Australia look increasingly attractive.
Corporate credit continues to look expensive, and the spreads are near all-time tights. As always, it is very hard to exactly time the moment of a spread widening. As such, given our long duration bias we still prefer to include some credit exposure across our portfolios as a diversifier and source of carry if a more benign environment for growth were to unfold. Within such credit exposure we are however very selective.
Fund specific risks
- Derivative risk – the strategy may use derivatives to generate returns and/or to reduce costs and the overall risk of the portfolio. Using derivatives can involve a higher level of risk. A small movement in the price of an underlying investment may result in a disproportionately large movement in the price of the derivative investment.
- Contingent convertible bonds – The strategy may invest in contingent convertible bonds. These instruments may experience material losses based on certain trigger events. Specifically these triggers may result in a partial or total loss of value, or the investments may be converted into equity, both of which are likely to entail significant losses.
- Sub investment grade bonds – The strategy may invest a significant portion of its assets in securities which are those rated below investment grade by a credit rating agency. They are considered to have a greater risk of loss of capital or failing to meet their income payment obligations than higher rated investment grade bonds.
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