Jim Leaviss
CIO, Fixed Income

16 min read

Key takeaways:

  • While we believe inflation and interest rates are on a downward trend, the descent could be bumpy and they could settle at higher levels than previously.
  • Central banks are approaching rate cuts cautiously but as policies diverge there could be opportunities for active bond investors to diversify across geographies and sectors.
  • The prospect of rate cuts is a potential opportunity for fixed income investors and we believe the current macroeconomic environment remains relatively supportive for investment grade credit.

Marketing communication

Since the beginning of the year, investors’ hopes of significant rate cuts in 2024 have been dented by data points showing that inflation was proving stickier than expected, as well as resilient growth and a strong jobs market in the US.

As we enter the second half of the year, markets are now pricing in two cuts of 25 basis points each by the Fed for this year. The Fixed Income team explores how long might rates stay elevated for and what the final landing point might be.

Where do we think inflation will go from here?

After ticking up for three consecutive months, April’s US Consumer Price Index (CPI) numbers landed in line with expectations, with year-on-year core inflation registering at 3.6%, the smallest number in three years, while headline inflation decreased to 3.4% year-on-year1.

This number offered a relief for markets, indicating that inflation is continuing to ease and restoring hopes that rate cuts are once more on the horizon.

We believe that inflation is on a downwards trajectory. We view stubbornly high rents as one key contributor to the recent higher than expected US inflation numbers. Rents are typically ‘stickier’, in part due to the calculation methodology used by the Bureau of Labor Statistics and the nature of the rental market. Historically, housing market trends have been a leading indicator for rent inflation with house prices typically leading rent inflation by about 18 months. House prices have stabilised following a recent surge, suggesting that rent inflation is likely to continue moderating throughout 2024. Therefore, we believe that one of the stickiest categories in the CPI basket is trending in the right direction.

Furthermore, one of the key drivers of inflation is money supply, with periods of significant inflation characterised by excessive money printing. The Fed undertook significant quantitative easing (QE) in response to the Covid-19 pandemic. However, since June 2022, the central bank began the process of quantitative tightening (QT). As a result, its balance sheet has been reduced by about $1.6 trillion from a peak of near $9 trillion in early 2022. Money supply tends to lead inflation by approximately 18 months and therefore we believe this reduction supports the assumption that inflation will continue to ease throughout the year.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Wherever mentioned, past performance is not a guide to future performance.

The views expressed in this document should not be taken as a recommendation, advice or forecast and they should not be considered as a recommendation to purchase or sell any particular security.

Bumpy path to inflation target

However, while we believe inflation is moving in the right direction, there may yet be some bumps along the road.  

While April’s inflation data offered markets a slight reprieve, 3.6% is still well above the Fed’s 2% target and several Fed policymakers have adopted ‘higher for longer’ rhetoric following the release. For example, Atlanta Fed President Raphael Bostic commented that the new “steady state” for interest rates is likely to be higher than experienced over the last decade. 

The road to lower rates is littered with obstacles with potential impacts from a still resilient economy and jobs market, as well as the US presidential election in November. 

Both geopolitics and the US election raise the potential risk of a resurgence of inflation. With US Treasury interest payments on a 12-month cumulative basis hitting $1 trillion in March and both presidential candidates campaigning on potentially inflationary policies, such as increased tariffs, there are some concerns about US fiscal sustainability. 

Furthermore, there is an argument that inflation, and interest rates, have entered a new era and will remain higher. Factors such as the green transition, prolonged periods of heightened geopolitical tension and demographic trends could see the so-called ‘neutral rate’ – the level at which interest rates neither stimulate nor hold back the economy – settle at a higher level.

While we believe interest rates and inflation are heading downwards, questions linger over the speed at which they will ease.

Policy divergence

Since the beginning of the current rate hiking cycle in 2022, most developed market central banks have moved in step with one another. However, with the path of inflation and growth moving at different rates globally, we are beginning to see central bank policy diverge, with developed market (DM) central banks now beginning to act independently of the Fed.

Following the Swiss National Bank, Sweden’s Riksbank and the Bank of Canada, the European Central Bank (ECB) has become the latest central bank to start easing monetary policy. The ECB has cut interest rates from record highs, in response to inflation falling close to the bank’s 2% target. Markets are pricing in another rate cut this year. 

These early moves are in contrast to the scaled back expectations for Fed cuts. ECB president Christine Lagarde has emphasised that the ECB was “data dependent”, not “Fed dependent”. She added that the two inflations (eurozone and US) are not the same. Eurozone annual inflation fell to 2.4% in April, close to the ECB’s target, while economic growth in the bloc was stagnant in the fourth quarter of 2023 before recovering slightly to grow 0.3% in Q1 2024.

However, central banks are proceeding cautiously as cutting rates ahead of the US risks currency depreciation, which in turn could spark an upswing in inflation from more expensive imports.

The Bank of England is also largely expected to reduce interest rates with futures pricing in an almost 100% chance of a cut at its August meeting2. This comes following a sharp fall in the UK’s inflation rate to 2.3% in April.

Emerging market central banks led the cycle by hiking faster and further than developed market central banks in an initial response to the uptick in inflation. As a result, these banks subsequently began their cutting cycle earlier, with Brazil making its first cut in August 2023.

As central banks diverge on the path down from the peak, we see potential opportunities for investors to diversify across geographies and sectors. Diverging paths could also make the descent from peak rates more perilous, making active management especially important, particularly within fixed income.

What does the current environment mean for bonds and where are the opportunities?

Fixed income markets saw a strong and rapid rally in the fourth quarter of 2023, leading many investors to fear that they had missed out. 

However, as it became clear that the 7 interest rate cuts originally priced in for the US for 2024 were unlikely to materialise, DM sovereign markets gave back some of their gains in the first few months of the year. 

As such, for those who missed out on the bond rush in Q4 2023, the prospect of rate cuts on the horizon provides another potential opportunity to capture attractive gains. As we highlighted in the previous edition of Investment Perspectives, the beginning of the easing cycle can be highly supportive of fixed income markets. 

Historically the 10-year US government bond (Treasury) tends to rally after the end of the Fed’s hiking cycle. For example, on average, if you bought a 10-year Treasury 63 days before the first Fed cut, you would see a 7% capital gain from a 1% fall in yield, plus the carry, according to research by Deutsche Bank3. As such, investing in Treasuries at the peak of the cycle has the potential to deliver a healthy capital gain from a credit risk-free asset.

Supportive environment for credit

While we are looking to position more defensively, we believe the current macroeconomic environment remains relatively supportive for investment grade (IG) credit, with inflationary pressures slowly easing, while growth remains supported by a healthy labour market.

Many IG companies remain in a strong position, having locked in low financing costs for an extended period and thereby insulating themselves from interest rate increases. Additionally, their large cash balances are earning attractive interest rates, allowing them to benefit from higher rates and providing them with a liquidity cushion. As a result, despite higher rates, most IG corporates’ balance sheets remain healthy with cash balances and profit margins remaining high.

The enthusiasm for IG credit is demonstrated by the record volumes of new issuance in the first quarter of 2024, as companies seek to take advantage of strong investor demand. Corporate borrowers issued $606 billion worth of dollar bonds in the first quarter of 2024, the highest total since at least 19902 as investors sought to secure high yields before the Fed begins loosening policy.

[1] https://www.reuters.com/world/uk/with-inflation-falling-fast-will-boe-quickly-cut-rates-2024-05-21/
[2] https://www.ft.com/content/2b16f721-007d-4148-b4b7-bca15d054bed

Actively seeking value in short-dated credit

Matthew Russell

Fixed Income Fund Manager

The US Treasury yield curve has been inverted since July 2022, the longest continuous inversion ever.3 Yield curve inversion is when short-term bonds yield more than longer-dated bonds. This occurs as investors expect the Federal Reserve (Fed) to hold short-term interest rates higher before cutting in the longer term. An inverted yield curve is widely considered as an indicator of an impending recession.

However, an environment where the yield curve is highly inverted also means bond investors could benefit from higher yields at the front end of the curve, without taking as much interest rate, or duration, risk. (Longer dated bonds are more sensitive to changes in interest rates).

The Fed and other central banks have raised borrowing costs aggressively in the past couple of years, in response to soaring inflation. This has been a challenging environment for bonds. However, at the end of last year fixed income markets rallied on expectations that the rate hiking cycle was at an end. There was a substantial opportunity for returns. However, for investors to profit from this was highly dependent on making the correct duration call.

In such an uncertain environment, investing in short-dated bonds can reduce duration risks, decrease downside risks and bring down volatility. By reducing duration, there is less pressure to make a correct call on the timing of the Fed’s interest rate decisions. The current curve inversion shows that the market is still expecting rate cuts ahead, in our view. If these were to be adjusted and yields rise, it could result in losses for long duration assets. (Yields move in opposite directions to prices).

As a result, we believe active bond management is as important as ever. As we move through the cycle, spreads will likely tighten on different sectors and bonds, which can provide a rich source of alpha-generating opportunities for active managers; credit selection capabilities are crucial as a volatile market environment can increase dispersion between individual credit valuations.

Furthermore, M&G’s credit research capabilities help to ensure that credits we invest in look robust, especially when spreads are tight. This can help avoid credits which are likely to lose value. 

Adding value

Our investment universe is not restricted to euro-denominated debt, giving us a wider opportunity set to look for excess returns. For example, a company may issue bonds in sterling, euros and dollars and have the same maturity, duration and credit risk; we have the potential to capture the widest spread and highest yield after hedging back to euros. These plays incrementally add to performance which is how an active manager can add alpha.

We are also able to add value by investing in floating rate notes (FRNs), debt instruments with coupons that fluctuate with interest rates, and asset-backed securities (ABS).

Investing in FRNs enables us to take credit risk with a low level of interest rate risk. Meanwhile, AAA- rated ABS can offer a similar risk premium to BBB unsecured credit. Our approach is to take risk when we believe we are being paid for doing so. With one of the biggest teams of ABS analysts in Europe, we believe we can effectively conduct due diligence and hunt for relative value.

[3] https://www.reuters.com/markets/rates-bonds/us-treasury-key-yield-curve-inversion-becomes-longest-record-2024-03-21/#:~:text=The%20part%20of%20the%20Treasury,ones%20%2D%20since%20early%20July%202022

A proactive, disciplined approach to credit

Wolfgang Bauer

Fixed Income Fund Manager

While we avoid taking an overall macroeconomic view, we cannot ignore the overall picture; we take an assessment of perceived risks and opportunities.

Currently, we believe there is a mismatch between the risks and what is priced in in many parts of the credit world; in our view, there are many areas where there is not adequate compensation for these risks and therefore, we believe it is important to derisk in certain areas, ready to deploy capital once there is sufficient compensation. 

Lingering inflation

One of the risks facing markets at the moment is lingering inflation; while the inflation picture has improved over the last 12 months, core inflation has proven to be a lot stickier than hoped by both central banks and markets. We believe we have probably seen peak rates and we are unlikely to see a meaningful reacceleration in inflation or higher rates. However, the main risk is that core inflation lingers significantly above target, which in turn could slow down the pace of central bank rate cuts. 

This brings its own risks; interest rate markets have already experienced a reality check since December 2023, as it became apparent the scale of rate cuts priced in was unlikely to occur. Yet, this was largely ignored by credit markets. 

Pressure of higher refinancing costs

However, higher rates mean higher refinancing costs for companies. While many companies are in a strong position to tolerate higher refinancing costs, the riskier parts of the market may experience pressure should the “higher for longer” scenario play out. This is a risk which we don’t see as fully priced in.

Default rates have slowly started to rise, especially in the US. While still at reasonably low levels, they are trending higher as would be expected given higher refinancing rates. The longer higher rates persist, the more likely we will see an acceleration in default rates as some companies may be merely playing for time.

As such, it is important to take a selective, active approach by looking at individual companies and understanding which are suited to survive and thrive in this environment, and which might be challenged with too much debt.

Tight spreads

In Europe, while there has been some tentatively good news in the latest data points for the purchasing managers indices (PMI), the manufacturing component remains in contractionary territory. Therefore, there remains a risk that Europe will continue to flirt with recession for longer than anticipated, which might pose a challenge for some companies’ profitability. 

Despite these risks, credit spreads have done very well, not least due to the relentless inflows into the asset class. Many institutional investors re-entered the asset class as yields increased sharply throughout 2022 and 2023. 

These inflows into the asset class have put strong downward forces on credit spreads, leading to the current spread compression. While this trend may continue for some time as yields remain reasonably high compared to where they have been historically over the last five years, flows into the asset class may ultimately start to stutter due to diminishing risk premiums.

Proactive approach

Currently we have been taking a measured derisking where we feel that valuations no longer justified the risks. In turn, we have built up defensive assets that fulfil three conditions; they should be short-dated, default remote (highly rated) and highly liquid. If the market begins to sell off, we would want to be in a position to swiftly liquidate these positions and buy riskier credit at better valuations. However, we still believe there are pockets of value, particularly within financials and real estate.

We will never be able to perfectly time the market; instead, we have to steer cautiously and be proactive, rather than reactive. We need to be disciplined and sell risk when it is getting expensive. We prefer to derisk into strength and build up liquid “war chests” so if markets sell off and valuations become more attractive, we can deploy capital quickly. The beauty of this approach is that we are not dependent on market timings.

Prospects for optimal income

Richard Woolnough

Fixed Income Fund Manager

The opportunity to deploy cash and increase duration in investment portfolios has re-emerged for the second time in the space of just under a year, in our view. In October 2023, yields on US 10-year Treasuries surged to 5% as higher-than-expected inflation drove investors to rethink their interest rate predictions (smaller-sized cuts – and fewer). Currently, yields are once again approaching the highs seen in this cycle. 

But back then, the surge in yields – and subsequent decline – occurred rapidly, leaving many investors behind. Since then, many of these investors have held onto cash with the intent to deploy it when valuations become attractive again. While the market doesn't often offer second chances, it seems that investors may have another opportunity this time around – and we argue it really is time to be active, flexible and well-informed in your bond selection, because of this unique rates-inflation dynamic.

We think there are three key reasons why duration should be added in the coming months:

  1. Rate cuts have almost been priced out: Market movements often fluctuate between extremes rather than following a smooth path. While the Fed has maintained a consistent message, market participants have been mainly erratic, shifting from expectations of ‘higher for longer’ rates to forecasts of multiple rate cuts in 2024-25. Presently, investors have mainly returned to the higher for longer mindset, with almost no cuts, or very few, priced in for this year. Consequently, while this can change in the coming months, we still believe most of the negative news has already been factored into the market.

  2. The recent upside surprises in US inflation have spooked some investors to believe that pricing pressures are making a comeback. We have argued against this view for a while now: As long as money supply remains constrained, it is difficult to achieve a sustained and significant inflation ‘reacceleration’. At present, money supply is still contracting and it would seem that we are now moving into an environment of "too little money chasing too many goods". This scenario is disinflationary and therefore typically a positive for duration. While some level of ‘sticky inflation’ may persist, we suggest that there is no need to be overly concerned about inflationary pressures. 

  3. We believe the risk-reward proposition for owning duration (eg, US government bonds) remains strong. In our view, the downside risk associated with holding government bonds appears limited, while the potential upside offers the possibility of double-digit returns. The chart below – which is based on M&G’s internal scenarios of expectations for total returns of 10-year US government bonds – illustrates our belief that risk-reward for duration-bearing assets has improved. 

In summary, we believe the opportunity to deploy cash and increase duration in investment portfolios has re-emerged as a result of a unique rates-inflation dynamic, one that has largely come from the central bank response to the Covid pandemic of 2020-21. This may be the final chance for investors to take advantage of the situation, however. In our view, the Optimal Income strategy remains well positioned in this environment with a historically high duration position of 7 years within a high credit quality portfolio (average rating of A).

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