Finding strength in developed market fixed income
Uncertainty in the geopolitical and economic environment can throw up opportunities, but near-term consolidation is possible
FIXED-INCOME assets posted solid returns in the third quarter, continuing the developed market (DM) bond bull market that arose from the ashes of the 2022 bear market. We are optimistic on the broad fixed income outlook, although now, as at every point along the way, questions remain.
We are past the peak in rates, but how low will they go? Moderation in economic activity and inflation have spurred central banks to ease, but will the softer growth picture threaten the outlook for credit products?
So far, the bull market has not really been fuelled by a shift lower in yields – bund and Treasury yields are near the same levels as in the fall of 2022, when the bull market began. Instead, the strong returns have largely been the result of simply earning yield itself and capturing the strong excess returns from credit products as spreads have narrowed.
How low will rates go?
On short-term interest rates, central banks are poised to continue cutting their policy targets. Given the current trend of economic moderation, the potential has opened up for a return to the pre-Covid secular stagnation levels. Considering the heavy degree of yield curve inversion – 10-year Treasury and bund yields are both at least one percentage point below their respective cash rates – a substantial amount of optimism regarding economic moderation and rate cuts is already factored into long-term yields. That may limit their scope to decline further in the short term.
As a result, long rates may consolidate around current levels until a clearer picture emerges regarding the terminal rates for the DM central bank rate-cutting cycles. With short rates falling as central banks ease policy and longer rates consolidating, the yield curve is poised to continue gradually steepening.
Bullish caveat for DM economies
One point worth considering is that DM economies averted recessions in this cycle despite the steep rise in interest rates. This raises another important question: If the current DM expansions have been fairly insensitive to the significant central bank rate increases, maybe the same will hold on the way down.
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That is, if the European Central Bank wants growth to pick up to at least 1 per cent or higher, and the Fed wants growth to accelerate at least enough to curtail further deterioration in the labour market, they may have to cut rates much more than expected in order to get the desired effect. If this is the case, then rates may be set to fall below consensus expectations in this rate cutting cycle.
Spreads: the “priced-to-perfection” problem
Spreads are near historic lows, leaving little room for capital appreciation from further compression. Does this mean the bull market in spread product is over? We guess not, although excess returns going forward are likely to be relatively measured, resulting more from incremental yield rather than additional spread narrowing.
No doubt the level of spreads, as well as anxiety about the economic and geopolitical environment, are giving investors pause. Yet credit fundamentals have remained relatively solid and, while growth is moderating, central banks have switched their focus to spurring growth and appear on track to achieve soft landings. The balance of factors suggests spreads are likely to remain range-bound, fluctuating around their historic tights.
As surging equity prices have undoubtedly boosted equity allocations for some investors, cash balances also continue to mount. Money market fund balances are at elevated levels in both absolute terms as well as relative to nominal gross domestic product.
While the question remains as to when concerns may come home to roost regarding stock market valuations, the appeal of cash is clearly under threat as central banks cut rates. As cash rates fall, investors may be spurred to extend out on the curve and into spread product in order to lock in yields for the long term.
Bond fund inflows – which are already running strong – are likely to swell further as cash yields decline and the search for yield intensifies. This dynamic should generally exert downward pressure on yields and keep spreads near their all-time tights.
Confidence in bond bull market
While a near-term consolidation is possible in the wake of the third quarter’s stunning drop in rates, our prognosis for the market remains relatively unchanged. With yields and spreads set to remain relatively range bound, investors should earn solid returns from fixed income.
Our one adjustment in Q4 is that, with the economic situation downshifting and rate cutting cycles now starting in earnest, the intermediate to longer-term prospects for falling rates to boost returns have improved.
Meanwhile, the one constant in recent years – the high degree of uncertainty regarding the political, geopolitical, and economic environment – is likely to continue to generate both confusion and opportunities to add value through active management.
The bottom line is that some near-term consolidation is possible. But overall, the favourable outlook for fixed income returns over the intermediate to long term remains, thanks to rates and spreads that appear range-bound or set to decline from current levels.
The writer is the chief investment strategist and head of global bonds at PGIM Fixed Income
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