The bond markets are facing a conundrum. US interest rates are at the highest level in more than two decades. Yet economic growth continues to be resilient, and the labour market has stayed strong, underpinning surging stock prices. And forward inflation is showing signs of being sticky.

Expectations of a recession induced by tight monetary policy has been belied. Investors are left guessing about the timing and depth of rate cuts by the US Federal Reserve. Money markets pricing shows less than 50 basis points of interest rate cuts by the Fed this year, compared to 75 basis points expected by its officials.

The Fed’s job isn’t made easier by the pickup in price pressures, with PCE inflation, the Fed’s favourite gauge to measure inflation, showing signs of stubbornness. The central bank’s efforts to push inflation down towards its 2% target is compounded by low unemployment rate, which has raised consumer confidence and boosted spending.

Even so, inflation has declined from the peak seen last year, thanks to the aggressive monetary policy intervention as well as increased immigration, which has kept a lid on rising wage costs. The resultant rise in real income, along with an accommodative fiscal policy, continue to support demand in the economy.

Real rates vs Real GDP

Investors have already dialled back on their rate cut expectations this year and it isn’t clear yet whether the Fed will start cutting rates in the summer or autumn. The conventional wisdom is that growth could be crimped and future job prospects hurt if rates prevailed at a high level for an extended period. However, we believe the question that bond investors should ask is whether the monetary policy is really tight?

Our analysis shows that real rates are still low, compared to the levels that existed during previous recessions, including the global financial crisis. For the policy to be restrictive, real rates need to be above the GDP growth. But that isn’t the case now. With so much in financial markets analysis, it’s about relative rather than absolute values.

Policy is still accommodative

Source: Bloomberg 16/04/2024

The chart above shows the relative value between real rates (Fed Funds rate minus core PCE) and real US GDP, relative to recessions in the US. Historically, we’ve seen that a recession mostly followed when US real rates reigned 1% above GDP growth. However, at this moment in time, US real rates are 0.4% below GDP growth, suggesting that investors can still find a higher return investing in the economy than in cash, and that policy is ultimately still accommodative. Alongside robust US government spending and a strong labour market, it’s hard to perceive where the slowdown will come from, let alone a recession.

No man’s land

What does this macro setting mean for bonds? In hindsight, we can say that the bond markets went too far in terms of rate cut expectations in the last few weeks of 2023. However, those expectations have since moderated and the front-end of the curve is more or less priced appropriately.

However, owning longer-dated bonds continue to be tricky as investors will effectively earn a negative carry from day one as cash provides better returns than coupon yields on government bonds. Therefore, we’ve had a bearish slant to rates in recent times. This has induced a tension in the bond markets and created volatility as a gap still exists between where the rates are and where they are expected to be. This might remain until a rate cut happens and the future path becomes clear.

Even if investors wanted to go long bonds, the negative carry is deterring them from making any bold moves. Right now, the market is stuck in a no man’s land. We believe a catalyst is needed to make the market more bullish.

Overall, we believe the monetary policy still isn’t as tight enough to deter economic activity and this is corroborated by subdued financial conditions. The uptick in inflation in recent months after a steep slide in recent months is a reflection of this fact. In this tricky environment, we believe the Fed could be constrained from aggressively cutting rates in the coming months.

In this scenario, it would be useful to consider a strategy such as Jupiter’s Strategic Absolute Return Bond as it’s designed to perform even in challenging environments. The strategy taps a large investment universe with an aim to create a balanced and diversified portfolio with stable levels of volatility uncorrelated to bond and equity market conditions. The emphasis is on flexibility and liquidity. The portfolio is continually tweaked to reflect the changing macro environment. This kind of nimble approach, in our view, would help fixed income investors in managing any macro backdrop effectively.

Investment risk:

While the Strategy aims to deliver above zero performance irrespective of market conditions, there can be no guarantee this aim will be achieved. Furthermore, the actual volatility of the Strategy may be above or below the expected range and may also exceed its maximum expected volatility. A capital loss of some or all of the amount invested may occur. Emerging Markets risk: Less developed countries may face more political, economic or structural challenges than developed countries. Credit risk: The issuer of a bond or a similar investment within the Strategy may not pay income or repay capital to the Strategy when due. Bonds which are rated below investment grade are considered to have a higher risk exposure with respect to meeting their payment obligations. CoCos and other investments with loss absorbing features: The strategy may hold investments with loss-absorbing features, including up to 20% in contingent convertible bonds (CoCos). These investments may be subject to regulatory intervention and/or specific trigger events relating to regulatory capital levels falling to a pre-specified point. This is a different risk to traditional bonds and may result in their conversion to company shares, or a partial or total loss of value.

Bond connect risk: The rules of the Bond Connect scheme may not always permit the strategy to sell its assets and may cause the strategy to suffer losses on an investment.

Interest rate risk: Investments in bonds are affected by interest rates and inflation trends which may affect the value of the strategy.

Liquidity risk: Some investments may become hard to value or sell at a desired time and price. In extreme circumstances this may affect the strategy’s ability to meet redemption requests upon demand.

Derivative risk: The Investment Manager uses derivatives to generate returns and/or to reduce costs and the overall risk of the Strategy. 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. Derivatives also involve counterparty risk where the institutions acting as counterparty to derivatives may not meet their contractual obligations.

Currency risk: The strategy can be exposed to different currencies. The value of your shares may rise and fall as a result of exchange rate movements.

ESG and sustainability: Investments are selected or excluded on both financial and non-financial criteria. The strategy’s performance may differ from the broader market or other strategies that not utilise ESG / Sustainability criteria when selecting investments.

ESG equity data: The strategy uses data from third-parties (which may include providers for research, reports, screenings and/or analysis such as index providers and consultants) and that information or data may be incomplete, in accurate or inconsistent.

The value of active minds: independent thinking

A key feature of Jupiter’s investment approach is that we eschew the adoption of a house view, instead preferring to allow our specialist fund managers to formulate their own opinions on their asset class. As a result, it should be noted that any views expressed – including on matters relating to environmental, social and governance considerations – are those of the author(s), and may differ from views held by other Jupiter investment professionals.

Important information

This document is intended for investment professionals* and is not for the use or benefit of other persons, including retail investors, except in Hong Kong. This document is for informational purposes only and is not investment advice. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing, are not necessarily those of Jupiter as a whole, and may be subject to change. This is particularly true during periods of rapidly changing market circumstances. Every effort is made to ensure the accuracy of the information, but no assurance or warranties are given. Holding examples are for illustrative purposes only and are not a recommendation to buy or sell. Issued in the UK by Jupiter Asset Management Limited (JAM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ is authorised and regulated by the Financial Conduct Authority. Issued in the EU by Jupiter Asset Management International S.A. (JAMI), registered address: 5, Rue Heienhaff, Senningerberg L-1736, Luxembourg which is authorised and regulated by the Commission de Surveillance du Secteur Financier. For investors in Hong Kong: Issued by Jupiter Asset Management (Hong Kong) Limited (JAM HK) and has not been reviewed by the Securities and Futures Commission. No part of this document may be reproduced in any manner without the prior permission of JAM/JAMI/JAM HK.

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