Displaying items by tag: duration

Stocks and bonds were both down following comments by Federal Reserve Governor Christopher Waller that rate cuts will be implemented slowly. Both are now in the red on a YTD basis. According to Waller, “When the time is right to begin lowering rates, I believe it can and should be lowered methodically and carefully.” As opposed to previous cycles, when cuts were implemented aggressively and quickly, Waller sees a slower, more gradual pace this time around. 

His comments had a chilling effect, especially as financial markets had been in a buoyant mood, looking ahead to rate cuts later this year and the possibility of a ‘soft landing’. While Waller injected a dose of hawkishness, recent economic data has also been on the weak side, adding to recession fears. Needless to say, such developments reduce the odds of a ‘soft landing’ scenario.

Currently, Fed futures markets indicate a 60% chance of a cut at the March FOMC meeting. Going into that meeting, inflation and labor market data will be major factors in this decision and market-moving events. Q4 earnings season is also starting, and it will be worth watching whether the improvement in Q3 will continue. The current consensus is for S&P 500 Q4 earnings to increase by 1.6% compared to last year.  

Finsum: Stocks and bonds weakened following hawkish comments from Fed Governor Waller. Waller sees a slower pace of rate cuts during this cycle than previous ones.

PIMCO sees a changed environment in 2024 as the Fed will pivot to rate cuts. However, it sees the impact of prior rate hikes still impacting economies and leading to stagnation or a mild contraction. 

Financial markets will be focusing on the timing and pace of rate cuts. Based on history, central banks don’t ease in anticipation of economic weakness. Instead, they tend to cut only after recessionary conditions materialize and tend to cut more than expected by the market. 

PIMCO agrees with Chair Powell that inflation and growth risks are now more ‘symmetrical’. However, it believes the market is underpricing recession risk especially given that some assets are already priced for a soft landing given the strong rally in many assets over the past few months. 

It also believes that fixed income is particularly appropriate for this environment given that yields are still close to multi-decade highs. It also offers protection and upside in the event of economic conditions deteriorating. Within the asset class, it favors mortgage-backed securities and believes investors should stick to medium-duration bonds as yields are attractive while interest rate risk is reduced. On a longer-term basis, PIMCO sees neutral policy rates to reach similar levels to before the pandemic which is also supportive of the category. 

Finsum: PIMCO sees financial conditions easing in 2024 as the Fed cuts rates, but economic conditions will deteriorate given the delayed impact of tight monetary policy.

2023 was an unprecedented year for interest rate volatility. The yield on the 10-year reached a low of 3.3% in April following the regional banking crisis, peaked at 5% in October, and finished the year at 3.8% following a series of supportive inflation data.

Given that inflation has declined to 3.1% which is nearly 70% less than the highest levels of 2021, the odds of a soft landing continue to rise. Currently, the Fed’s plan is to loosen financial conditions by lowering the Fed funds rate, while it continues to shrink its balance sheet.

Part of the plan should also be to reduce bond market volatility especially since it has doubled over the past 2 years and remains elevated relative to norms. In some respects, elevated bond market volatility is a consequence of the Fed’s battle against inflation. Now, it must also effectively deal with this issue before it becomes more substantial. 

Therefore, it’s likely that the Fed will cut back on its quantitative tightening program in which $95 billion worth of maturing bonds are not reinvested. Already, these efforts have succeeded in shrinking the Fed’s balance sheet by 15%. Another reason that curbing bond market volatility is necessary is that the Treasury will be auctioning off large amounts of notes and bills in the coming months. 

Finsum: The Federal Reserve has made significant strides in turning inflation lower. Now, it must take steps to reduce bond market volatility.

It’s an interesting time for fixed income given the recent rally and optimism around inflation falling enough to cause a change in Fed policy. In conversations with clients, Nicholas Bragdon, Lord Abbet’s Associate Investment Strategist, discussed some common themes that are emerging. 

The first is that many clients report feeling satisfied with earning 5% returns in deposits and have no desire to make a change. While returns on cash are the highest in decades, the same is true across the fixed income universe even in short-duration assets like short-term corporate debt. Historical data also shows that being overweight in cash leads to long-term underperformance while also leading to reinvestment risk in the event that the Fed does start cutting rates. 

Another common concern among clients is that they believe they will have sufficient time to make changes to their portfolio if the Fed does start cutting rates. However, history shows that it’s quite difficult to time these changes in rate policy. 

In fact, last year at this time, the consensus was for the economy to fall into a recession in the second-half of the year, leading the Fed to start cutting rates. In reality, markets are too efficient and will have already priced in a bulk of gains by the time the Fed actually starts easing. Thus, investors should consider moving from cash or short-duration fixed income into intermediate or longer-duration to take advantage of the changing environment.

Finsum: Fixed income markets are at an interesting place, following a strong rally to end the year amid anticipation of a change in monetary policy. Here are some common client concerns. 

2023 was a year of twists and turns for fixed income, although it ended with a big rally in the final months of the year. In 2024, Schwab Fixed Income strategist Collin Martin forecasts positive returns for the asset class and believes that yields have already peaked. Additionally, he notes that bonds are once again a diversifier against equities after an ‘anomalous’ 2022, especially at current yields. 

Despite believing that yields have peaked, he remains bullish on the asset class, noting attractive opportunities to generate substantial income. However, investors will need to be selective in terms of duration and quality. Martin recommends longer-duration securities to take advantage of higher yields even if yields are currently higher in CDs, bank deposits, or Treasury bills. This is because longer-term yields at 4% are quite attractive, and it negates interest rate risk in the event of Fed rate cuts. 

Martin added that investors should prioritize quality especially since there is no additional compensation for taking on risk in lower-rated or high-yield debt given current spreads. Therefore, stick to Treasuries or high-quality corporate debt which offer generous yields with minimal risk. Both would also outperform in the event that economic conditions further deteriorate. 

Finsum: Schwab is bullish on fixed income in 2024 although it believes that investors need to be selective in terms of quality and duration.