Talking heads – Tapping into the wide fixed income opportunity set

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking heads podcast. Every week, Talking heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing the impact of rising central bank policy rates on fixed income markets. I’m Daniel Morris, chief market strategist, and I’m joined by Cedric Bernard-Villeneuve, portfolio manager in our absolute return team. Welcome, Cedric, and thanks for joining me.

Cédric Bernard-Villeneuve: Hi, Daniel, thanks for having me.

DM: This is a highly relevant time to be talking about the impact of higher policy rates on fixed income markets. Of course, none of this should have been a surprise. We all knew – and have discussed for years – that the extraordinary monetary policy measures following the Global Financial Crisis would eventually have to be unwound, and that it was probably not going to be a particularly pleasant process.

We had the liability-driven investment (LDI) turmoil in the UK, we had the FTX and crypto market turmoil. And now we have banks failing in the US and worries about the European banking sector. What all this highlights is the dilemma that the central banks face. On the one hand, they need to hike policy rates because inflation is too high; but we also need to appreciate that the increase we’ve had in policy rates in such a short period of time is inevitably going to upset parts of the market. We’ve seen that recently. So, Cedric, to start off, could you lay out the macroeconomic or financial context for what we’re seeing in the markets?

CB-V: Let me take a step back and make sure our listeners understand why we have arrived where we are, and why we are facing this dilemma, which is on every investor’s mind at the moment.

In basic terms, by raising interest rates, the Federal Reserve is making borrowing money costlier and saving money more attractive. Next, banks will raise their mortgage rates to maintain their profit margin. As a result, families will no longer be able to afford to buy a house. It’s a domino effect. This will cascade to estate agents or realtors who are making much less money because there are far fewer transactions. People will be going less frequently to restaurants. This will impact the wait staff in those restaurants and the restaurant owners, who will see fewer clients. The restaurant owners will try to avoid raising prices and may actually offer discounts to attract new customers, so prices drop. This closes the loop of higher rates bringing down demand, which lowers inflation.

Of course, it’s a lot more complicated. Central bankers have to balance how much demand they destroy with how much they want to bring down inflation. The problem is when the unemployment rate starts rising, even by a small amount, it usually keeps going much higher, which makes the job of fine-tuning demand destruction even more complex for central bankers.

Economists estimate that the unemployment rate can increase by two percentage points to five or six percentage points. Having the US unemployment rate go from 4% to 7% is highly plausible, based on history. So, the job of central bankers is about finding the right balance between demand destruction and bringing inflation down. The inflation crisis that we are now facing is highly unusual and broad-based, which explains why the Fed has had to increase rates so much – by around 450 basis points – since March 2022. This amount of monetary policy tightening has many implications for businesses, particularly for businesses closely integrated with the financial markets, like banks, insurers or pension funds. We saw the UK pension fund system being put under a lot of stress in September 2022, and we are almost seeing a repeat of that episode in the banking industry at the moment.

DM: What’s interesting about what we’re going through now is the unpleasant echoes it seems to have with the Global Financial Crisis. We believed that, with the tightening of financial sector regulation in the US and Europe, we wouldn’t see a repeat of that episode – that if there was a new crisis in the market, it would come from somewhere else. As it happens, we have the US banking sector at the core of all of this.

Perhaps the most interesting question is “What do the central banks do about all of this?” We talk about the Fed put – that whenever markets go down by a significant amount, the Fed or other central banks will cut rates to stabilise the markets. The concern is that that makes investors complacent because they can always count on the central banks to bail them out. Except when that happened, inflation was low. So, there wasn’t that much risk if the Fed or the central banks cut rates.

However, the Fed is now in a quite uncomfortable situation. On the one hand, we clearly see the volatility in the markets and concerns that the increase in interest rates is creating instability. But, as we’ve seen with recent inflation data in the US and the eurozone, inflation is still well above their targets. So what should the central banks do? And what will they do?

CBV: This is probably the question every investor is asking at the moment, whether or not they are exposed to the US market. Unfortunately, the answer may not be straightforward.

The Fed is the lender of last resort and its founding mission back in 1913 when it was created was to bring back stability to the banking sector in the United States. So when the Fed announced its new bank term funding programme, it was exactly about helping to stabilise the banking sector.

The Fed wants to avoid contagion to the entire banking system, which could create a lot of instability and make its job of fighting inflation even more complex. This brings us to the Fed’s other mandate – to promote maximum employment and stable prices.

The important reason why the Fed may not pause on its hiking path is that it’s about using the right tool for the right job. This framework was better explained by (former Fed chair) Ben Bernanke in 2002. As a general rule, the Fed will do best by focusing its monetary policy instrument on achieving price stability and maximum, sustainable employment. It should use its regulatory, supervisory and lender-of-last-resort power to help to ensure financial stability.

On that basis, one could assume that the Fed will continue raising rates by 50 basis points. Unfortunately, it’s not that easy. If we look at the numbers, small and medium-sized banks play a very important role in the US economy. Banks with less than USD 250 billion in assets account for roughly 50% of US commercial and industrial lending. They account for around 60% of residential real estate lending and about 45% of consumer lending.

So stress at those banks means we can almost be sure that they will tighten lending standards and that is going to weigh on aggregate demand; it will in a way help the Fed to bring inflation down. So that’s why the Fed is going to take that into consideration when it assesses how much it will have to hike from here on. It may be that slowing the pace of hiking from 50 basis points to 25 basis points is very sensible.

DM: You’ve described a challenging environment. At the same time, you are a portfolio manager for an absolute return fund, which means you have a wide opportunity set of instruments that you can invest in. You have to take into account that particularly high volatility in fixed income recently. This is in notable contrast to previous episodes of market turbulence, when it was mainly equity markets that saw the volatility. How are you managing your portfolios in this environment?

CBV: One of the good things about being able to invest globally in the fixed income sector is that we can reallocate our ideas and our views across a broad range of markets.

At the moment, there is a case for the Fed to continue hiking as inflation is still present in the US economy. What we like is playing the US underperformance versus what we consider to be leveraged economies like Australia, Canada, Sweden. The way we do that is by shorting the US rates market going long those leveraged economies.

We think the terminal rate in the US should be a little bit higher than where it is now. We think those leverage economies have tolerated the build-up in debt, particularly in their housing markets, and that in this higher rate environment it is going to be highly challenging for their central banks to hike rates as much as they would need to bring inflation down. Hence our being short duration in the US against long duration in those economies.

Other type of trades we like at the moment are a short duration trade, in the Japanese economy for example, as we think the Bank of Japan will be under heavy pressure to normalise its policy, and we believe that will put some stress on Japan’s rates market. The normalisation of central banks’ policy rates is also putting pressure on yield curves, so we are positioning for steeper curves, meaning that the longer rates are going to sell off much faster. These are the trades in our portfolios in Europe and the US at the moment.

DM: Cedric, thank you very much for joining me.

CBV: Thanks a lot for having me. It was a great pleasure.