Chart 1: The Fed's tightening campaigns
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Investment Ideas for
Fixed Income Markets
March 2024
Key Themes:
MARCH 2024
Is the current rate cycle writing its own script?
The Federal Reserve’s (Fed) tightening campaign that began in early 2022, and arguably peaked last July with the effective federal funds rate (EFFR) reaching 5.33%, and the impact it’s had on longer term rates, has mostly followed history.
Chart 1 shows the previous Fed tightening campaigns and their impact on rates, dating back to the early 1980s. What it reveals is that while a few months late, ultimately the 10 Year US Treasury Yield, after reaching a high of around 5% in October 2023, sharply rallied to 3.79% by the close of the year. But here is where the current rate cycle appears to be writing its own script.
Source: Bloombery Finance L.P., as at 31 December 2023.
Testing conditions for the Fed
Expansionary fiscal policy, infrastructure and CapEx spending are all driving inflation, making the Fed’s job of managing price stability all the more harder. Despite these considerations, the US economy is proving to be resilient in the wake of the central bank’s epic tightening campaign.
As a result, inflation is proving to be stubbornly “sticky” on its glide path back to “normal”. But finding “normal” in a less globalised world, where domestic labor enjoys more support than it has had since the early 1980s, and where there is an emerging and voracious new demand for electricity tied into the rapid emergence of generative AI technology, is proving to be illusory. Meanwhile, the ghost of Arthur Burns and his ill-fated decision to prematurely ease policy in late 1974 looms over today's Fed.
Where next for the Fed?
As implied above, anticipating Fed action and its impact on the overall Treasury yield curve is complex. Consider a strong case that current monetary policy is too restrictive. After all, 6-month annualised Core personal consumption expenditure (PCE) inflation is hovering around 2%, while the unemployment rate sits at 3.9%. This means that the Fed is delivering on its mandate of providing an environment of price stability and full employment.
If everything is “just right” from an economic and inflation perspective, the Fed’s neutral rate of interest (r*) is 2.5%, while the current EFFR is 5.33%.
Nevertheless, with so many cross currents impacting the domestic and global economy, today’s Fed is going to wait and see before it begins cutting rates.
To this end, Jerome Powell appears to be more focused on year-over-year core PCE that currently sits at 3.2%. It may also be that in a less globalised, more inflationary world, the Fed’s understood r* at 2.5% may need to be revised higher.
Through this lens, and in a manner consistent with last week’s Fixed Income Policy Week that highlighted domestic and global economic resilience, both the market and T. Rowe Price expect the Fed to cut only three times this year (down from six plus rate cut expectations just weeks ago). The first cut is expected to come in June. Even this guidance, interestingly, is a moving target as conviction is waning from market as well our perspectives on both the scale and timing of anticipated Fed action this year.
Against this backdrop, the following highlights emerged from last week’s Fixed Income Policy Week:
- With their floating rate coupon not being aggressively reduced in conjunction with “sticky” Fed Policy, as well as favorable fundamentals, floating rate bank loans are the best performing global fixed income asset class year-to-date.
- While on a delay, a credit cycle looms as the T. Rowe Price high yield team has forecasted a 4.28% default rate for the high yield asset class this year.
More telling in terms of a looming credit cycle that may be exacerbated with a Fed that is hesitant to ease, is the following perspective from T. Rowe Price’s high yield team:
“…In the wake of ZIRP (zero interest rate policy) and the Covid-era cash stimulus, there are many debtors who should not exist as currently capitalized. As debts come due, there simply is not enough corporate cost cutting available to offset the increase in interest expense due to current market rates. Barring a substantial decrease in the risk-free rate, more in-court restructuring is set to occur over time.”
And if an array of private companies is "hanging on" and are not going to get much, if any, help from Fed easing, such companies will get creative while credit markets remain wide open.
“A recent slew of private deals that have been refinanced into the public markets suggest a hunger among borrowers for interest savings, the analysts wrote. Many companies can save 200 to 300 basis points when opting for public debt over a direct loan, Moody's found. So far this year, 21 companies have issued a broadly syndicated loan to refinance USD8.3 billion of debt that was previously provided by direct lenders, according to PitchBook LCD data.”
-Moody’s Says Private Credit Returns Will Be Pressured by Banks, Bloomberg, 6 March 2024.
Right now, the T. Rowe Price fixed income team views a 4.5% 10 Year US Treasury yield as a level to pursue being at least duration neutral across related strategies.
The bottom line
What follows the first reaction function to peak Fed funds is a credit cycle that appears to be just beginning. And in this environment, T. Rowe Price fixed income is well positioned. Active management and platform discipline, with regard to capacity, are going to matter greatly going forward.
Investment ideas for this environment
T. Rowe Price Dynamic Global Bond Fund
The T. Rowe Price Dynamic Global Bond Fund is a portfolio of global fixed-income securities seeking to deliver sustainable income and manage downside risk.
Past performance is not a reliable indicator of future performance.
T. Rowe Price Global High Income Fund
The T. Rowe Price Global High Income Fund seeks high income and capital appreciation by investing primarily in global, below-investment grade corporate debt securities.
Past performance is not a reliable indicator of future performance.
FEBRUARY 2024
The waiting…and the dynamics
As discussed in January 2024’s note, a strong argument existed for the Fed to begin cutting interest rates as soon as March. Core PCE inflation was running near 2% (based on its 6-month annualised trend) while the unemployment rate was arguably depicting full employment at 3.7%. With price stability and full employment “in play”, the thinking was that a Fed pivot to a more “neutral” policy rate stance warranted more immediate attention.
Inflation surprises to the upside
But several considerations have emerged since January, and even as recent as the conclusion of last week’s February Policy Week, which have ruled out a Fed March cut and cast doubt on Fed action in May.
At the top of this list is domestic and global economic resilience, which has demonstrated additional strength in recent weeks. The Federal Reserve of Atlanta’s GDP estimates the US economy growing at a 3.4% pace in real time. With such strength, the Fed has made it clear that they would like to see more proof that the benign inflation trends that have been in place for the past six months are indeed sustainable.
Beyond economic endurance and now near-term prescience from the Fed, February 13th’s headline CPI print surprised to the upside by coming in at 3.1% (YoY). Some were expecting the measure to come in below 3%. Importantly, an uptick in core services as well as in “shelter” inflation, which lifted Core CPI to 3.9% on a YoY basis, was also part of this print.
Are rate cuts still on the cards?
Beyond the upward inflationary pressure referenced above, core goods prices fell further, which leaves the “goods” deflation story intact. Meanwhile, the details of the report “show an odd divergence between the Owners Equivalent Rent (OER) and actual rent price data.” With all of the above said and now the need to wait for informational clarity gaining traction before any Fed action takes place, we believe Tuesday’s CPI print does serve to “make the Fed more cautious”.
In terms of quantifying what such caution means for markets, the probability of a May rate cut is now 40%, which also makes the scale and timing of what follows next for the Fed fluid. With this said, the policy expectation gap between the Fed and markets has largely closed with 3.5 (25 bps) rate cuts now expected by December.
A reversal of fortune
December 2023’s massive move in US rates (the 10 Year US Treasury moved from 4.32% in late November to 3.87% by year end) has now completely reversed itself.
With a USD34 trillion national debt in the US and a USD2 trillion annual budget deficit, it begs the question as to who the ultimate buyers are going to be for a significant wave of developed world sovereign debt coming to market this year now that the Fed is higher for longer. As such, the firm’s expectation is that the domestic yield curve’s reaction function to eventual Fed easing of monetary policy will be somewhat unique relative to history.
Resilient global growth
As referenced above, US and international growth has been resilient with areas such as Europe bouncing higher off previous softer levels of growth from a real time perspective. And while the world’s second largest economy is struggling from an historic and property sector perspective, China is still growing its economy at 5% and exerting more global influence than financial headlines would imply, as the country remains as the world’s global export leader.
The bottom line
With rates above 4% and tight credit spreads, we believe adding duration to hedge credit risk is and will continue to be less reliable until the market has a better sense of when inflation ultimately settles. This then allows the Fed to begin cutting rates. Until then and beyond, we view that T. Rowe Price Dynamic Credit and Dynamic Global Bond belong in client conversations.
With active profiles that include negative duration positions, unique correlation profiles and strong long term track records, we believe T. Rowe Price Dynamic Credit and Dynamic Global Bond warrant attention as complements to more traditional fixed income allocations in an environment where “the waiting is the hardest part…”.
One additional note in relation to last week’s Policy Week and its aftermath worthy of scrutiny relative to the comments above is a correlation study (between rates and credit risk assets) conducted by the firm’s Fixed Income Quant team that offered portfolio construction ideas such as:
“We see that adding rates to a credit portfolio works nicely during selloffs when rates are lower. This is the positive convexity we are looking for. However, this protection fades at higher levels of rates. When the 10Y Treasury Yield is over 4%, this has been the weakest…”
JANUARY 2024
Fed Action Required…
T. Rowe Price expects the US Federal Reserve (Fed) to begin cutting policy rates with a “base case” that such action begins in May 24. How many cuts remains open to question as a significant easing of financial conditions late last year, a seismic wave of developed world sovereign supply soon coming to market and the disruption of oil supply in the Red Sea complicate the Fed’s mission of maintaining full employment at a level that is consistent with ongoing price stability.
Nevertheless, the Firm’s fixed income division expects at least three rate cuts this year with as many as six cuts or more, some potentially in 50 bps increments, before the US autumn with the US Presidential election looming later this year.
Soft landing?
With the domestic unemployment rate residing at less than 4%, while Core Personal Consumption Expenditures (PCE) inflation hovers in real time near the Fed’s target of 2% (see below), the premise that the US economy is currently experiencing a “soft landing” economic outcome was acknowledged. But before celebrating the Fed on a job well done, as they have been able to bring sharply elevated pandemic policy induced inflation to heel without triggering a recession, the realisation that today’s benign economic outcome is not a destination, but instead is a tenuous moment within a cycle was also discussed.
If the most real time inflation trends in Core PCE are indeed able to remain in the range of the Fed’s preferred inflation target, then a strong argument can be made that current domestic monetary policy is far too restrictive. In other words, the current “soft landing” state of the US economy can only endure with help from the Fed as the economy and inflation have arguably reached pivotal post pandemic points of inflection.
Inflection point
Identifying points of inflection from recent trends are important as they reveal a future that is certain to be unique relative to the recent past. Today, as referenced above, this consideration matters greatly with regard to inflation. With the economic and inflation “distortions” that followed the world’s US$25 trillion policy response to the pandemic largely gone, the reemergence of the importance of the Fed’s preferred measure of inflation—Core PCE that excludes food and energy—has arrived just as (referenced above) the 6-month annualised rate for this inflation gauge hovers in the Fed’s target range of 2%. In addition, even though inflation remains broadly elevated relative to pre-pandemic levels; as reported by Bloomberg on 11 December 2023, inflation views among Americans over 60 years old have retreated to a three-year low. As a result, inflation, both from quantitative and qualitative perception perspectives, is closer to where the Fed wants it to be than is generally perceived, which has implications for domestic monetary policy.
Two key foundations of pre-pandemic US monetary policy included a Core PCE Inflation target of 2% and an r* (an equilibrium or neutral policy rate that is neither restrictive nor accommodative) of 2.5%. And while much has changed since late 2019 in terms of deglobalisation trends and more uncertain geopolitics, which imply that these pivotal foundations now need to be adjusted upward; in a world that has largely normalised from pandemic policy distortions, Core PCE and an idea of where a neutral r* Fed Funds rate should be remain key to understanding where Fed policy goes from here.
Connecting these dots
If the Fed’s targeted policy rate is 2.5% (at the time of writing it hasn’t changed…), then the Fed’s preferred “real” r* neutral rate is 0.5%. Now consider where “real” current Fed policy rests with “real” Fed Funds now hovering in the range of 3.25% to 3.5% relative to a target of 0.5%. Through this lens, even if there are some changes to the notion of what the r* neutral rate should be, as referenced above, the Fed now has more significant room to cut rates. Said a different way, the current “soft landing” profile of the US economy is not sustainable with “real” monetary policy so restrictive. and this argument does not even consider Quantitative Tightening, which continues in the background. The math discussed above is illustrated below:
Source: Analysis by T. Rowe Price.
For now, technical considerations, where rate expectations became overpriced and overbought late last year with elevated sovereign supply still to come, have flipped “bearish”, which leaves a 10-year US Treasury yield range of 3.85% to 4.30% as guidance for US rate direction beyond Fed Funds to expect for now.
Lastly, the T. Rowe Price Fixed Income strategy that stood out in the current environment is the Below Investment Grade Credit (High Yield and Bank Loans), which delivered a stellar 2023 and remains positioned for an environment where active management will matter more as tight “spread” levels get tested this year and into next.
Additional Disclosures
Unless otherwise stated, all data is provided by Bloomberg Finance L.P., as at 17 January 2024.
T. Rowe Price Supporting Research
Investment ideas for this environment
T. Rowe Price Global High Income Fund
The T. Rowe Price Global High Income Fund seeks high income and capital appreciation by investing primarily in global, below-investment grade corporate debt securities.
DECEMBER 2023
The Fed now looks to "stick the landing"
The US Federal Reserve (Fed) attempt to normalise monetary policy off of extremes to a level that not only restores price stability from pandemic extremes, but does so without sending the US economy into recession is no small feat. Adding even more complexity to the Fed’s current challenge are certain market participants that are feverishly expressing their interpretation of the Fed’s every word in the form of extreme market actions which since early November have eased financial conditions to a point where they may actually help drive future Fed action in a direction that could squelch the bullish “risk on” narrative that has overtaken markets as 2023 comes to a close.
It is against this backdrop that what looked to be a benign December meeting, where the Fed would potentially confirm a “pause” in its policy rate tightening campaign relative to the dichotomy of favorably declining inflation trends versus a still resilient US economy, became so much more. Even in the wake of an epic November cross asset rally, the Fed surprised markets in December by communicating that they were not only done raising rates but then additionally nullified the notion of “higher for longer” with a “dot plot” indicating three potential rate cuts next year. It is through this lens that as 2023 ends, the Fed appears to have found with a stance that will now seemingly seek to “stick a landing” where price as well as economic stability are on the table for next year. As a result, consensus has overwhelmingly grasped onto a “soft” to “no” economic landing view for 2024 which has extended November’s cross asset rally but even more broadly in terms of asset classes impacted.
Highlights of the T. Rowe Price’s December Policy Week that took place amid the dynamic market conditions referenced above include:
- Barring exogenous shocks, the US economy remains resilient enough with a 1.5% to 2% growth profile through the next two to three quarters which may allow the US to escape recession all together next year.
- The view that the Fed, beginning in May, cuts rates twice next year is now fluid. It could be sooner and may now be two to three cuts. While aligned with the Fed, this view stands in contrast to broader market consensus that see 5 or more cuts next year that begin in March if not sooner.
- Of off what has been a furious duration rally since late October, T. Rowe Price Fixed Income expects some retracement of current US Treasury yields. This range allows for flexibility in managing through what is likely to continue to be a volatile rate environment where multiple economic data soon to be released take on heightened importance with the more “dovish” stance articulated by the Fed in December.
- While “Goldilocks” may be too strong of a description for the current environment, a “no landing” outcome is supportive of risk assets for the foreseeable future.
Fixed Income subsectors that we believe look attractive from a valuations perspective include:
- Emerging Market Local – Even with additional stimulus now supporting it, China remains as a deflationary economic malaise story which ties into its failed property sector. This has an impact on developing world economies who were first to address inflation in the wake of pandemic policy response and who have been selectively easing policy rates YTD.
- Synthetic Credit in High Yield as well as Crossover Credit – While risk assets remain supported for now, liquid credit that allows for continued upside participation, but which can also be quickly traded in a market sentiment shift remains attractive.
- Commercial Mortgage Backed Securities – Select opportunity exists in what is equating to a slow motion asset class turnaround story.
Lastly, T. Rowe Price Fixed Income strategies that stand out in the current environment include:
- Below Investment Grade Credit (High Yield and Bank Loans) – Delivered a stellar 2023 and remain positioned for an environment where active management will matter more as tight “spread” levels get tested next year.
- Short Duration Fixed Income – With the Fed now being ready to cut, but medium to longer term rates having already run, T. Rowe Price Short Duration fixed income strategies have executed well and now may make sense as an area to extend duration despite expected retracement of medium to long term yields from current levels.
Past investment ideas and themes
NOVEMBER 2023
"Fragile Equilibrium"
In recent weeks, amid a vacillating rates environment that continues to have Wall Street perplexed with regard to starkly divergent views of what to expect next, Fixed Income’s Head of Global Investment Grade, Steve Boothe, aptly described recent market action as ultimately coalescing into a near term “fragile equilibrium” as 2023 concludes.
Thanks to expansionary fiscal policy, a resilient US consumer as well as “onshoring” tailwinds, the US is the best house in a global economic neighborhood that is flirting with recession. But a resilient US economy that is also good for credit fundamentals, in conjunction with US inflation still remaining well above the Federal Reserve’s 2% inflation target, appears to also have the Federal Reserve on hold into late 2024 from T. Rowe Price’s perspective. Meanwhile, following massive US rate short covering and a surprisingly benign domestic CPI print on November 14th, the 10-year US Treasury Yield has found a near term yield range between 4.25% and 5.00%. While rates have been rallying, disappointing Treasury auctions related to US fiscal sustainability can quickly change the direction of rates, which helps drive a wide yield forecast range.
Beyond this seeming near term equilibrium is fragility stemming from uncertain geopolitics as well as questions raised by rating agencies and more around the fiscal sustainability of the US. Importantly, today’s narrative is fluid and near term “fragility” is becoming less so as receding inflation allows the Federal Reserve to be “done”, while signs of détente between the US and China have emerged as the leaders of the world’s two largest economies have constructively met just as reports have surfaced that China may be lifting its freeze on Boeing’s 737 Max aircraft. But while hope has emerged for fraught US / Sino relations, tragedy and complexity remain about conflicts in Ukraine as well as the Middle East.
The survey results that kick started the fixed income division’s November 6th policy week have been prescient in capturing the investment themes that have played out since with the following take: “…there remains high uncertainty on US nominal yields, but risks are tilted towards lower yields. The slightly more bullish outlook on nominal yields helps explain the stable outlook for risk assets and a less positive view on the US dollar…”
Overall highlights to note against what has become a swirling yet constructive current narrative include:
- A weakening but still resilient US economy where a “no to soft” economic landing in 2024 appears likely,
- A Federal Reserve on hold until late 2024 as service economy inflation trends still remain sticky and elevated but will be carefully watched as the division’s US economist, Blerina Uruci, sees Core CPI in the range of 2.6% by this time next year as she expects that inflation deceleration spreads more broadly to “services” CPI including shelter during 2024,
- T. Rowe Price’s view of a slow moving Federal Reserve in 2024 runs counter to a market that has “run” with this week’s constructive CPI print and now expects 5 rate cuts next year, which has been quickly priced into risk assets. To the extent that the firm is correct on prospective Fed action from here, a weaker US Dollar right now would likely stabilize,
- A volatile but range bound US rate term structure,
- This overall backdrop is constructive for credit overall where fundamentals remain sound and while spreads are “compressed”, their absolute yields remain compelling.
Bottom Line – While T. Rowe Price is not quite calling for a “goldilocks” 2024 investment and economic environment as some on Wall Street have been quick to pronounce, the current backdrop is constructive.
Regardless of what camp you are in (higher for longer, “goldilocks” or recession in ’24, etc.), T. Rowe Price Fixed Income has strategy building blocks with strong strategic track records to meet all client needs in today’s dynamic fixed income investment environment.
OCTOBER 2023
A “real” challenge has emerged for the US economy and risk assets
The Minneapolis Fed, in their 2016 paper, “Real Interest Rates over the Long Run”, argued that the “single most important price in an economy may well be its real (inflation-adjusted) interest rate as it is a “critical factor in almost every decision faced by households, businesses, and governments about whether to spend now and later.”
Between domestic corporations responsibly pushing their debt maturity walls well into the future, the preponderance of US homeowning consumers locking in historically low 30 year fixed rate mortgage rates and expansionary fiscal policy that has run counter to the US Federal Reserves (Fed) ambition to slow the economy to quell still elevated inflation that remains beyond their target, the US economy has proven to be resilient even through a Fed tightening campaign that has taken its policy rate from the zero bound in early 2022 to now 5.25%. Beyond prudent interest risk rate management at the corporate and individual levels, one way to explain this phenomenon is that the financial system has continued to operate in nominal terms where corporations have been able to efficiently pass elevated costs onto their customers while the consumer has been buoyed by pandemic policy largesse as well as wage gains that are associated with an unemployment rate that remains below 4%. Importantly, this benign economic narrative now begins to face an additional challenge beyond a restrictive Fed in the form of materially higher real rates which influence economic behavior as highlighted by the Minneapolis Fed above.
While still well above the Fed’s preferred 2% target, inflation has been falling year to date. Meanwhile, as discussed CIO Arif Husain’s white paper, The Fairy Tale of a Soft Landing, yield levels, beyond short maturities, are determined by market forces beyond Fed policy. Today, this consideration arguably matters more in that longer-term interest rates are being factored in a less globalised and more geopolitically uncertain world as well as against debt to GDP levels that haven’t been this elevated since WWII. In addition, in the near term, global governments need to sell a “ton” of new bonds which raises the following key question from the white paper referenced above:
“Who will buy all of this duration, especially at a time when central banks are stepping back from bond purchases? The implication is higher long-term bond yields…”
Indeed, longer maturity US and developed market Treasury yields have been rising at a pace in recent months that has exceeded the pace of Fed hikes as evidenced by the 20 Year US Treasury yield which has climbed from 3.66% on April 6th to 5.07% on October 16th. Not surprisingly, the market has quickly latched onto this volatile nominal rate narrative in terms of assessing whether the US and other developed economies can handle “higher for longer”. But such a narrow focus misses the more material consideration that when longer-term nominal yields increase while inflation has been falling it also means that “real yields” (nominal yields less inflation) are rising.
As illustrated in the two charts below, higher real yields are not only helping tighten overall financial conditions, but are also proving to arguably influence, for now, the direction of global equities.
1.) Real Yields arguably impact financial conditions and right now they are tightening…
Past performance is not a reliable indicator of future performance.
Source: Bloomberg Finance L.P., as at 16 October 2023.
Note that the yield on the left vertical axis is measured in percentage.
2.) And global equity markets appear to be paying attention
(note the equity level on the right vertical axis is inverted in the chart)
Past performance is not a reliable indicator of future performance.
Source: Bloomberg Finance L.P., as at 16 October 2023.
Note that the yield on the left vertical axis is measured in percentage.
Bottom Line – Monetary policy operates on a lag and in the current environment, for reasons discussed above, the wait for the impact of restrictive monetary policy has arguably been even longer. But now sharply rising yields in longer maturity Treasuries and stubbornly receding inflation are driving real yields higher. The good news is that these developments are helping the Fed do their job in slowing the economy which raises the probability that peak Fed Funds may already be here. The bad news in higher real yields is that they have negative economic consequences.
For now, against the backdrop of material developed world fiscal deficits that need to get termed out at a time of arguable tepid demand, the direction of longer maturity Treasuries appears to be higher. With its focus on adept active management with a global focus, T. Rowe Price Fixed Income has been effective so far in navigating what has been a volatile rate journey that also represents select opportunity. What remains is an historically attractive opportunity to extend duration, which, at this moment, appears to await in 2024. Stay tuned…
Additional Disclosures
Unless otherwise stated, all data is provided by Bloomberg Finance L.P., as at 16 October 2023.
SEPTEMBER 2023
“Who’s Next?”
Amid the flux of a Fitch rating agency downgrade for the US, looming elevated Treasury supply and the broader recognition of a higher Fed Funds rate for longer to quell a resilient US economy that continues to carry elevated inflation levels beyond monetary policy comfort; the US Treasury market found it necessary to make concessions to bring in new investors to clear trades in intermediate to long maturities during the first three weeks of August. Consider last month’s sharp move in 30 Year US Treasury yields, for example, that rose from 4% to 4.45% by August 21st, which drew immediate interest into the market as the “Long Bond” yield ended August at 4.21%.
This interest rate’s theme was discussed during the firm’s Fixed Income September Policy week in the context of setting expectations for where US rates go from here as the above referenced factors that drove intermediate to long maturity US Treasury yields higher during the first three weeks of August all remain. And with important “marginal” buyers having already entered the market last month, the question becomes “Who’s Next?” to absorb the elevated US Treasury supply coming to market this fall.
And with no easy answer available yet for this important question, T. Rowe Price Fixed Income generally believes the “highs” in yields reached in intermediate to long maturity US Treasuries could be revisited in the weeks to come. Meanwhile, with increased belief in a benign economic outcome for the US and domestic corporations having effectively termed out debt at attractive long-term yields while also being able to preserve margins for now, spreads remain tight across corporate spread sectors while even grinding tighter in more nuanced fixed income sectors such as Collateralized Loan Obligations.
Against this backdrop, the following highlights emerged from September’s Fixed Income Policy Week:
- Quantitative analytics from fixed income indicate that general risk appetite is supported for now while qualitative rationale for rising caution abounds.
- Meanwhile, with market consensus coming around to a general view of a “soft to no” landing for the US economy, which reinforces the notion of higher policy rates for longer, the US Dollar has been on a tear since mid-July with the US Dollar Index moving from 99 to 105 points as of 7 September 23. While general caution exists with regard to how far the US Dollar has come in recent weeks, positioning on the US Dollar across is mixed across the platform and should additionally be thought of within a portfolio context. Consider the Dynamic Global Bond team that continues to feature long US Dollar positioning as a favorable counterbalance to other active positioning within its strategy relative to its absolute return mandate.
- While the surface of global fixed income remains generally serene, the “bite” of elevated policy rates for longer begins to prominently factor into corporate interest expense in 2025 and beyond. Concessions for select credits to extend maturities in the current environment, for example, generally require a 200bps plus step up in yield to get done. Importantly, relative to a regional banking sector that remains under fundamental duress, private credit looks to an important avenue for extending credit maturities, which makes the firm’s still recent acquisition of Oak Hill Capital appear increasingly prescient.
- And in terms of eventual monetary policy “bite”, fixed income still believes in a heightened probability of US recession sometime during 2024 as elevated real yields and the lagged impact of tighter domestic monetary policy for longer ultimately catches up to what is right now an “exceptional” (relative to the rest of the world…) US economic story.
Fixed income strategies of heightened interest through September’s Policy Week include:
- Short and Ultra Short Duration Fixed Income to capture the theme of higher Fed Funds for longer.
- Floating Rate Debt which remains fundamentally well supported despite a rising default trend (the trend is moving back to long term historic averages).
- Dynamic Credit as a play on the importance of active management and diversification in investing in credit within the current spread compressed investment environment.
- Traditional domestic municipal bonds that appear well positioned to a looming “peak” domestic rate environment as well as benefitting from its uniquely favorable net negative supply technical foundation.
T. Rowe Price Supporting Research
JULY 2023
A slowing global economy and a case for
Emerging Market Debt
Held back by its troubled property sector and consumers reluctant to spend, hopes for a strong economic recovery in China following its reopening from the pandemic are fading. Meanwhile, while a resilient US economy is constructive, growth in Europe is also receding which, when combined with China’s economic malaise, represents pressure for the global economy. At this intersection, the saying “one individual’s trash can be another’s treasure” comes to mind. In contrast to flagging global growth being a headwind for equities, for example, it can be a tailwind for debt investors. Consider that in the current environment, slower global growth is also helping to quell elevated levels of inflation which brings the global rate cycle into focus.
This time was different as Emerging Markets policy makers led the way with regard to combatting the wave of global inflation that followed massive policy stimulus response to the pandemic. Interestingly, the prospective rate path forward from here looks smoother for developing world policy makers versus developed economies. Emerging Markets central banks, for example and as referenced above, started raising rates to combat recent inflation pressure well before the Federal Reserve and other developed markets policy makers. For context, consider that Brazil’s central bank first raised rates back in March 2021 and have since hiked more than 10 times to lift the Selic rate from 2% to the current level of 13.75%. Similarly, Mexico’s Central Bank kicked off its hiking cycle in June 2021 and has subsequently lifted rates more than 700 basis points to a record high of 11.25%. By being “early”, within a slowing growth and inflationary backdrop, certain Emerging Markets central banks now look poised to start cutting interest rates in the second half of this year and into next led by select Latin American countries and Hungary and Poland in Central and Eastern Europe.
As a result, while the Emerging Market debt asset class has enjoyed a strong year to date run, particularly in local currency markets benefitting from a weaker near term US Dollar, a turn in the global rate cycle led by Emerging Market bonds well for the Emerging Market Debt asset class going forward.
JUNE 2023
Is it time to add duration?
While resilient, global growth is showing signs of slowing which helps clear a path for lower prospective inflation levels that have remained “sticky” and elevated. As a result, global central banks are moving closer to the end of a global monetary policy tightening cycle that followed the pandemic. Against this backdrop, we believe it is time to start leaning into duration, but active management remains paramount.
Transition periods for central bank regimes are rarely, if ever, smooth. The US Federal Reserve’s (the Fed) decision to “pause” on 14 June 23, for example, stands in contrast to the central banks of Australia, Canada and the UK who have all recently raised their respective policy rates.
Beyond near term developed world central bank disharmony, the aftermath of the debt ceiling resolution in the US also means that approximately US$1 trillion in US T-bill issuance will be hitting fixed income markets in the weeks ahead which is likely to increase overall rate volatility.
In addition, part of the Fed’s message in mid-June is to expect additional hikes from here relative to economic resilience that has surfaced since early March. Meanwhile, led by expected declines in Owners’ Equivalent Rent (OER) and the Auto sector, inflation in the US is poised to materially recede in the next twelve months. Amid such flux, the US Treasury Yield curve remains inverted, which also means that “negative carry” exists as a consideration to avoid for today’s fixed income investors. In addition, concerns around a looming credit cycle, regional bank tension that remains and the need for active security selection also exist while yield curve trading execution also figures prominently at this point of inflexion for central bank policy.
Amid this heightened period of uncertainty, the following three considerations emerge:
- Just as is the case for equity investors striving to time market tops and bottoms, perfectly timing a call on duration is difficult, if not impossible.
- Nevertheless, directionality, as identified by our global research platform, is an opportunity to be exploited which right now is sending a message to “lean in” on adding to duration. In terms of quantifying “leaning in”, consider the flexible duration range of the firm’s Dynamic Global Bond strategy that spans -1 year to 6 years of duration and its representative portfolio is now positioned with a 4.5 year duration stance as of 31 May 2023.
- While adding duration warrants consideration, the complexity of today’s investment environment, where a higher Fed Funds rate for longer and distorted yield curves along with a credit cycle amplifies the need for a nuanced approach where active management delivered by our Fixed Income division will matter greatly.
T. Rowe Price Supporting Research
MAY 2023
1. Do you believe the Fed will cut rates this year?
2. US dollar influence wanes as inflation is expected to soften
Inflation remains “sticky” and elevated, which also means that the US Federal Reserve (the Fed) is unlikely to cut rates at all this year which runs counter to current forward market indicators. But inflation relief looks to be on the way.
With Owners’ Equivalent Rent (OER) poised to fade in the back of this year just as the labor market is expected to weaken, inflationary pressure should ease to the point where the Fed can begin easing rates toward an equilibrium level some time (potentially H1) next year.
- This broader disinflationary narrative comes at a time of wider data dissonance between manufacturing (cooling) and services (firm). Amidst the wider debate on whether it is the opportune time to add duration at this time (read more: Rates Volatility to Continue as Economic Outlook Evolves), one other trend is becoming clearer: the fading of the U.S. dollar’s multi-decade rise and influence (read more: A New Dollar Smile: Where Next for the U.S. Dollar?).
Consider that in previous episodes of global monetary policy tightening, the Fed was typically the “Pied Piper” in setting policy and the world followed. This time, emerging market central banks like Brazil and Mexico were through with the bulk of their policy tightening before the Fed even fired their opening salvo in a collective war against inflation. Near term US Dollar weakness could also come from a divergence in policy bias. Countries are once again in different stages of their interest rate cycles (see chart), creating global bond and currency opportunities. Consider, for example, that as the Fed prepares to end its rate hiking campaign, the European Central Bank (ECB) has more work to do. For example, see the latest comments from ECB policymakers warning of rate hikes continuing beyond the summer.
Sources: IMF, CB Rates and T. Rowe Price
Beyond interest rate differential pressure, the US Dollar has other woes currently. Growing rumblings around the US debt ceiling and the ongoing troubles in the US regional banking space currently cloud, for example, the current picture of the US Dollar as a haven asset amid uncertainty. This set up appears to be supportive of non-dollar and emerging market debt at this time.
T. Rowe Price Supporting Research
Investment ideas for this environment:
The T. Rowe Price Dynamic Global Bond Fund is a portfolio of global fixed-income securities seeking to deliver sustainable income and manage downside risk.
Past performance is not a reliable indicator of future performance.
APRIL 2023
Don't Fight the Fed/Too Early for Rate Cuts
Yogi Berra said it best: “It’s like déjà vu all over again” – the market is ahead of itself again and is pricing multiple interest rate cuts this year. While a US Federal Reserve pause may be near, the switch to then cutting rates so quickly is unlikely given US inflation and labor market dynamics. Yes, inflation is cooling, but only moderately and not fast enough to force a Fed rethink especially given it remains materially above its 2% target. It is a similar story in the labor market – it may be loosening but only gradually and from extreme tightness. With this backdrop, cuts are probably off the table for 2023 and when markets come to this realization the 2-year Treasury yield will likely reprice higher. Also note that global monetary policy divergence trends are accelerating: for example, the ECB should continue hiking but with less conviction, and Australia is eyeing one final rate hike. This environment calls for an active duration and curve management approach to take advantage of interest rate market dislocations. Dynamic and flexible duration profile approaches appears to be compelling, in our view.
T. Rowe Price Supporting Research
Investment ideas for this environment:
T. Rowe Price Dynamic Global Bond Fund
The T. Rowe Price Dynamic Global Bond Fund is a portfolio of global fixed-income securities seeking to deliver sustainable income and manage downside risk.
Past performance is not a reliable indicator of future performance.
MARCH 2023
The Fed Was Bound to "Break" Something. What Happens Next?
In its fight against inflation, the US Federal Reserve has been tightening financial conditions to try to loosen the tight labor market. With such a rapid increase in policy rates over the past year, something was bound to “break” and some in the market fear the Silicon Valley Bank/Signature Bank closures are just the first dominos to fall.
The upshot has been markets quickly pricing out aggressive rate hikes and pricing in ~75-100 bps of rate cuts later this year, leading to one of the strongest rallies in US Treasury market history. Stock-bond correlations, which had been positive last year for the first time in many years, flipped back to negative.
Will this trend persist? It will be difficult if inflation remains high. The lag of monetary policy takes multiple quarters to filter through the real economy, so there is risk something else may “break”. As the US Federal Reserve fights on multiple fronts, we expect volatility to remain high. This market demands flexible investment strategies.
Investment ideas: Volatile environments call for flexible approaches that have fewer constraints, tend to be more global and/or have less correlation to Treasuries.
T. Rowe Price Supporting Research
Investment ideas for this environment:
T. Rowe Price Dynamic Global Bond Fund
The T. Rowe Price Dynamic Global Bond Fund is a portfolio of global fixed-income securities seeking to deliver sustainable income and manage downside risk.
Past performance is not a reliable indicator of future performance.
MARCH 2023
Flying Through a Liquidity Storm
The recent cracks in markets suggest that we may have reached a peak in short-dated yields around 5%. Typically, the market thumb rule suggests getting long 2-year rates as soon as the last US Federal Reserve rate hike is seen although this is muddied by historical experience in 1970s and 1980s and high inflation picture. Moreover, how much of the recent, ongoing regional bank and Credit Suisse turmoil damages broader confidence and starts to move through economic data is yet to be determined. Short-end and flexible duration profile approaches appears to be compelling, in our view.
Investment ideas for this environment:
T. Rowe Price Dynamic Global Bond Fund
The T. Rowe Price Dynamic Global Bond Fund is a portfolio of global fixed-income securities seeking to deliver sustainable income and manage downside risk.
Past performance is not a reliable indicator of future performance.
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The representative portfolio is an account in the composite we believe most closely reflects current portfolio management style for the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from those of other accounts in the strategy. The GIPS® Composite Report is available upon request.
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