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Cautious Hope for Fixed Income Investors

November 27, 2023 10 min 13 sec
Jeffrey Mayberry
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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

I’m Jeff Mayberry. I work for DoubleLine. I am a portfolio manager and a fixed income asset allocator.

Bond yields have been very interesting of late, have kind of bounced off the 5% level on the US 10-year recently, been running between this range of 5% and four and a half. And really after the September Fed meeting it did seem like people were starting to get worried that the issuance in the treasury market was really going to drive rates up.

But things seemed to have settled down based on the fact of a little bit weaker nonfarm payroll number that we did receive in the first week of November. We received CPI, consumer price index, in mid-November. That seemed to show a little bit of a slowdown in inflation, and so really things have started to calm down after the huge volatility that we’ve seen after the September Fed meeting.

Given the backdrop of the current macroeconomic environment almost across the globe, it does seem like most of the major central banks outside of, let’s say, the Bank of Japan, should be done hiking interest rates. There has tended to be a coordinated interest rate increases, and since the Fed leading the way, we’re certainly of the mindset that the Fed is going to try to stay higher for longer, but doesn’t seem like they’re not really planning to hike interest rates anymore, where we’ve been of the mindset since end of the second quarter that the Fed would be done, maybe one more rate hike.

So it seems like the Fed is going to lead the way for the rest of the central banks, outside of the Bank of Japan, which the Bank of Japan has a whole other problem where they’re really trying to get rates higher through their yield curve control. But the other major central banks across the globe were of the idea that they should be done hiking rates, or at least they won’t be hiking rates significantly from here.

It’ll be interesting to see when major central banks begin to cut rates. The market is pricing in rate cuts, or at least in the U.S., the market is pricing in Fed rate cuts to begin early next year into the first quarter, beginning of the second quarter.

And it’s really going to be interesting to see how things play out because I don’t really feel like the Fed is going to feel comfortable with inflation getting down towards their 2% goal anytime soon. And so the probability of the Fed cutting rates maybe is inflated because the probability of a recession in the beginning of the year or the end of the first quarter, beginning of the second quarter of 2024, is a little bit elevated.

So the rate cuts pricing in there, I would take them to mean that the U.S. is going to be in a recession and the Fed needs to cut rates. They’re not going to cut rates 25 basis points in that environment, they’re going to cut rates 200 basis points. So there’s, say, a 10% probability of a 200 basis point rate cut, and that just flows through into the probabilities as a 20 basis point rate cut.

Now, the market is also pricing in further rate cuts out the back half of the year. I think that’s much more likely for the Fed to start to fine-tune where the rate position, fine-tune that as inflation is getting a little bit more in line with where they want to see. But I think that they’re going to be very slow about that. They’ve tried to talk about higher for longer, and they’re going to try to reinforce that over time with all their Fed speak, with the press conferences that Jay Powell does, and really try to get the market to become a little bit more aware that the Fed’s not going to cut rates just because of a little bit of slowdown in the jobs or a little bit of slowdown in inflation. They need to get back to their 2% goal, and that’s their main goal, at least at this point in time.

Our outlook for fixed income is very positive, and obviously there’s been a lot of rate volatility, and that makes it a little bit, I would say, harder to manage but also more fun to manage because that means there’s more opportunities.

Taking on some credit risk today you can get in something like the fixed rate, high-yield market, low investment grade market, you can get close to a 9% yield. That’s the long-term outlook or long-term rate of return that people would expect from the U.S. stock market.

So if you can get that in high yield, if you can get that in a diversified basket of credit risk, then it makes sense to maybe allocate a little bit more to your fixed income market because you can get a larger percentage of your overall goal with a lower volatility.

Now, it’s not to say that we’re not shying away from your flight to quality, your safer securities also, but really being able to take on credit risk where it makes sense to take credit risk. We think a diversified mix of credit risk so you’re not going all in on U.S. corporate credit or emerging market debt or commercial mortgages or residential mortgages. Take a little bit on everywhere, being able to pick up opportunities across the universe really provides a good future outlook for fixed income.

When we do look at the fixed income market, our outlook definitely has an effect on how we view things. And so we’re not going all in on credit risk. We want to have a large allocation to what our boss, Jeffrey Gundlach, calls the sleep-at-night portion of the portfolio, which is typically U.S. treasuries. In something like a longer duration strategy like a Bloomberg aggregate focused strategy, we’ll buy the long bond in the U.S., the 10-year, try to get some duration from that side of things.

In a more shorter duration strategy, we’ll buy the two-year treasury. That’s not necessarily our favourite point on the curve, but it’s really providing us that dry powder for when there is the flight to quality, when there is the recession, the Fed cuts rates, the two-year will rally a lot. You can sell the two-year, that’s obviously gone up a lot, and buy some of your credit that has gone down. Spreads have widened a lot, there’s much more likely to be dislocations in the credit markets and you can really pick and choose where you want to be a little bit more opportunistic in that scenario.

And so we are kind of playing both sides of things. So we’re not all in on the Fed is going to engineer a soft landing, buying credit is okay. Also, the fact that maybe the Fed is going to, or if maybe the Fed has already tightened too much and they’re going to cause a recession, a harder landing, and you want to have treasuries in that portion of your portfolio.

So really having both of these pieces together allows us to feel comfortable, hence the sleep-at-night portion of the portfolio, and really be able to provide a higher yield than kind of the market, but also provide safety, and so you can work both sides of those scenarios.

This is what we really want to do in times like this where we’re at an inflection point where we can see the economy go either way, either the soft landing slash no landing scenario, or the hard landing scenario. We don’t know what’s going to happen, so let’s position the portfolios to take advantage of both scenarios and be able to outperform and then be able to add value in the future depending on which scenario plays out.

The future of interest rates obviously is very hard to predict, and I think that when we look at things we think that you could get, or one of the things we’re thinking about is that when we eventually get a recession, that you could get the reflexive rally in interest rates and the longer-term interest rates. As people go to their flight to quality, they want to buy the safest thing.

But then the underlying fundamentals of the U.S. treasury market are such that there’s so much supply out there, there’s more supply coming, and that no matter who is in charge, the deficit is rising. And so we think that there could be that reflexive drive down in interest rates, and then there could be the rise back up in interest rates. Even though maybe the recession isn’t over, maybe things are still getting worse, it could be that supply-demand dynamic overwhelming, or the supply side overwhelming the demand side, and you could see interest rates rise.

So we’re of the mind that you could move down, certainly not anywhere close to where we were pre-Covid or around that Covid area. We’re not going below 1% on the 10-year. I think we could get 2.5% on the 10-year, but then be aware of we’re not going to kind of stay at that 2.5%. We could go up higher from there and end up with that kind of higher for longer in long-term interest rates.

One of the things that we are worried about for the beginning of next year, beginning to middle of next year, is the probability of a recession rising. If you look at the U.S. two-year, 10-year treasury spread, that inverted in July of 2022, and usually that gives you a lead time of anywhere from 12 to 18 months to the start of a recession.

You also can look at the three-month to 10-year yield spread, that inverted in November of 2022. Similar timeframe, 12 to 18 months. So if you look at just both of those two indicators, then they would kind of point to on the longer end of things, the beginning of 2024 as the start of a recession.

Now we’re not going to look at just those two indicators by themselves and say, “Okay, we’re going to plan for a recession.” You look at something like the unemployment rate in the U.S., and it’s kind of ticked up to 3.9% off of the 3.4-3.5% lows that we’ve had earlier in the year. And really when that number starts to get above that 0.5% difference, that’s really indicative of the start of the recession.

Also, when the curve uninverts is a very good indicator of the start of a recession also. So kind of taking all these things into account, the 2-10 spread has recently been as low as a negative 17 basis points. Mid-November has widened out a little bit more. It remains to be seen whether it goes wider or more inverted or less inverted. But really, those are the indicators we’re looking at to kind of give us a clue on when a recession is going to start.

From a credit spread perspective, credit spreads are still very tight, so the market at least is not planning on a recession anytime soon. So that’s another thing to keep an eye on, whether it’s your high-yield spreads, whether those start to widen out in anticipation of recession. Those are the kind of indicators we’re looking at, but really we’re in the mindset of early to mid next year, 2024, be aware there’s that potential recession out there.