Fixed Income: The spotlight is on government bonds
Ariel Bezalel and Harry Richards examine the prospects for the US economy and the outlook for interest rates following the first rate cut in the current cycle.
The US Federal Reserve has finally kicked off its easing cycle by cutting its policy rate for the first time in more than four years, as it tries to minimise disruption to the economy from high interest rates.
While the 50-basis points reduction may have surprised many, we’ve been flagging that the Fed is way behind the curve in cutting rates. Ahead of the policy decision, the difference between the Fed Funds rate and the two-year Treasury bonds was the highest in 45 years. The front-end of the curve is the most sensitive to interest rate movements and the inversion signals that the market is pricing in deeper cuts in the coming months.
The balance of risks has changed
The job market continued to show a slowdown with an increase in the unemployment rate and a more muted pace of job creation, increasing the risks around the goal of maximum employment. Continued progress towards the 2% inflation target has instead reduced risks around the goal of price stability.
This has brought better balance between the two statutory targets of the Fed, demanding policy adjustment.
As a consequence, US Treasuries (Bloomberg US Aggregate Treasuries Index) have recovered losses suffered earlier in the year and posted positive returns in each month since May¹.
Notwithstanding the rally, US Treasuries might still offer some good value. The chart below shows that the beginning of the Fed’s rate-cutting cycle augurs well for US Treasuries. The chart, which captures data going back to 1973, shows an uptrend in total returns in the three years after the first rate cut in an easing cycle.
Good returns for US Treasuries follow the first rate cut
Source: Bloomberg, Jupiter, as at 30.04.24. US Treasuries is Bloomberg Treasuries Index.
While many market participants have been already flagging that most of the Treasury rally might be behind us, we would disagree with such an assessment. Historically markets tend to underprice the extent of monetary easing.
Fed Funds Rate vs. “Market Forecast” 18 months earlier
Error in “Market Forecast”
Source: Bloomberg, Jupiter. As of 16.09.24.
If anything, high quality government bonds and duration exposure look to us as interesting hedge at this juncture. If the economy were to slow down in a more meaningful way from here, the Fed and other central banks might be forced to accelerate the pace of easing, opening the space for additional yield compression. In that scenario, risk assets such as equities or credit, might suffer and high-quality bonds might once again provide strong diversification.
We believe that there might be some further weakening ahead for the US job market and the best days for US consumption might be behind us.
Other economies do not look particularly resilient either. The Eurozone shows anaemic economic growth and absence of credit creation, as higher energy prices and competition from China weigh on the industrial sector. China itself is still dealing with a major real estate crisis and policy support so far looks rather ineffective.
While the last few quarters have been brighter in the UK, we still see many headwinds ahead, such as high extent of mortgage repricing and limited fiscal room. Australia has recorded in lowest growth in the 30 years (COVID excluded) in the second quarter of 2024, while New Zealand’s GDP growth is already in negative territory.
Credit markets: lower exposure, less cyclicality and selectivity
We believe credit spreads are very tight given the risks to growth. As such, across our portfolios we have been reducing broad credit exposure over the past quarters.
We prefer to limit exposure to cyclical sectors such as retailers, chemicals and automobiles, focusing instead on “through the cycle businesses’’ with tangible assets such as telecommunications and cable networks. Financials and in particular CoCos with short call date still offer some decent value when compared to generic non-financial credit.
The Fed is the last of the major central banks to start cutting rates. Others such as the European Central Bank, the Bank of England and the Swiss National Bank too are already on an easing path. We expect this environment to give a fillip to government bonds as safety and returns will be important considerations for investors.
¹ Please note: Past performance is not a guide to future performance.