Catching the turn in bond markets

AS INFLATION eases globally, attention has turned to market expectations of rate cuts by major central banks, and what it could mean for fixed-income investors.

From an expected six US Federal Reserve rate cuts priced in for 2024 at the start of the year, expectations of cuts have been delayed, and the market is now pricing in only two or three cuts for the remainder of this year.

This comes alongside economic headwinds and tight monetary policy continuing to feed into the real economy. Fed chair Jerome Powell recently warned the US Congress that holding rates high for too long could jeopardise both growth and jobs.

Against this ever-evolving market backdrop, and despite historically tight spreads in the investment-grade (IG) space, the hunt for yield has not cooled and there are still pockets of opportunity ahead.

In this context, global investors are flooding into US IG bonds to position themselves to “catch the turn” when the rate cuts eventually arrive, which could set up high-quality US fixed-income markets well for a period of strong performance, should there be a suitable spark.

Catalysts for outperformance

While there is no crystal ball to predict the future of markets, there are signs that could signal a start to Fed rate cuts or spark a potential boost to US bond markets. One candidate to look out for is if US core inflation continues to fall. Inflation for US core consumer prices reached a three-year low in June, and there are good reasons to expect continued downward momentum in both core services and goods inflation.

An important component of core services inflation is owners’ equivalent rent (OER), which calculates what a property owner would pay in rent to live there. While this is not a direct measure of what a homeowner actually pays, it does nonetheless affect the inflation figures, and therefore influences monetary policy. Leading indicators suggest OER should continue to fall.

Prices for core goods also remain well above levels consistent with real input cost inflation. Therefore, any slowdown in demand should also support continued disinflation, which in turn would give the Fed more space to cut rates.

Another catalyst for the Fed to cut rates, is the impending slowdown in demand, which is driven by the struggling US consumer. Fewer Americans are now able to continue spending in the way that they have been doing since the pandemic. The stress on lower-income consumers is very well recognised. However, those in the middle-income band also feel their real income growth stalling, alongside depleted excess savings and ongoing cost-of-living pressures.

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Outlook for rate cuts

Our thesis is that the neutral real policy interest rate is far below where we are right now. We think the Fed will need to carry out cuts at a speed greater than what is currently priced by the market as inflation falls, and real policy rates become more restrictive as a result.

The speed of disinflation will dictate the speed at which these cuts can happen, with any shocks to the growth and labour market outlook accelerating this pace.

The wait for the cutting cycle to begin may have dragged on, but reasons to expect that the current consensus would be upended are only growing stronger. If and when this shift occurs, high-quality US bonds should fare well. Any surprise in growth or labour market data could trigger a rapid acceleration in the cutting cycle and catalyse a spell of US bond outperformance. In this environment, an agile approach and credit selection will remain vital.

The writer is portfolio manager at Fidelity International