Talking Heads – Que les taux aient atteint leurs plus hauts ou non, prenez les devants

This is an article based on the transcript of the recording of this Talking Heads podcast

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 US interest rates and the economic outlook. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Ken O’Donnell, Head of Short Duration. Welcome, Ken, and thanks for joining me.

Ken O’Donnell: Thanks for having me, Daniel.

DM: Over the last year, as a portfolio manager, you’ve seen the biggest increase in interest rates in a long time. How have short duration investors been impacted by interest rates that are high globally?

KO: These are extraordinary times – inflation has emerged across developed market economies in ways we haven’t seen in 40-odd years. As to what all this means for fixed income investors, the shift to restrictive monetary policy results in higher yields and eventually improves returns over time.

The transition from low to high interest rates was extremely painful for fixed income investors who are generally unaccustomed to experiencing mark-to-market losses in their bond portfolios. Short-term interest rates have reached levels we haven’t seen since before the Global Financial Crisis. In sharp contrast with just two years ago when we were earning zero yields, bonds currently enjoy a substantial yield cushion that can serve to offset and absorb market price swings.

The risk of negative returns going forward on fixed income is now low. From a relative value perspective, the sector appears attractive. If market yields remain the same or decline in a pattern consistent with what the market’s expecting, absolute returns could easily exceed 5%.

To put this in perspective, earning 5% returns when inflation is running at 5% year over year doesn’t really generate increased wealth, it simply maintains your future purchasing power. That’s true of most conservative investment strategies at the moment, with inflation running above historical norms.

But when you take a step back and compare the alternatives, given the limited downside [risk], investment-grade fixed income stands out as an asset class in this environment and should be the basis for most portfolios.

DM: The key debate right now is over recession and soft landing. We’ve had an inverted yield curve both in the US and the eurozone for most of this year, which we all assume is telling us recession is coming. Yet the credit markets and equity markets don’t seem to believe that. What’s your view?

KO: History can be a useful tool in providing guidance on the monetary policy cycle as a whole. Markets appear to be embracing a soft-landing scenario, with recent GDP prints coming out above expectations. Personal consumption is holding up and we’re starting to see a resumption of business spending. All that is positive.

But, historically, the soft-landing scenario is much less common than recession. The growth pendulum tends to swing past neutral in both directions, which results in cycles. Recessions and expansions are not created equal. They can differ in magnitude, depth and length. Fortunately, the last large recession that is burnt into everyone’s memory was the 2008 Global Financial Crisis, and that is unlikely to be repeated any time soon.

Economic conditions today are different. There is less debt and there are far fewer excesses in the system. When we speak of a recession in the context of today’s market or policy cycle, it is likely to be much milder and shorter than the GFC. A better comparison may be the 2001 recession, which lasted only about eight months and there was a two-point rise in unemployment from 4% to 6%. Another potential scenario is a growth recession, where quarterly GDP slows to close to zero, but doesn’t technically trigger a recession.

In both a recession or a growth recession, we would expect a moderate increase in unemployment, a reduction in consumption, a decline in corporate revenue and profitability, a weakening of risk assets (equities and credit spreads). In comparison to the GFC, we would consider this a soft landing. I say that to illustrate that the two scenarios – a mild recession and a growth recession – are not mutually exclusive. They share grey areas with similar economic outcomes.

If the US National Bureau of Economic Research was to declare a recession, that alone can result in behavioural triggers that tip the scales in one direction. This has a tendency to make things worse in the short run – reduced spending, delayed hiring, layoffs, essentially a general retrenchment – which can accelerate the process. In either case, we’re pushing towards lower growth and a higher risk of recession. Policy rates at or above 5% is usually restrictive enough to cause some pain to an economy, and that’s our base case.

DM: We know the manufacturing sector purchasing managers’ indices are already below 50, and retail sales in real terms are starting to weaken. How will the US Federal Reserve respond to that, especially if inflation hasn’t slowed yet?

KO: It all depends on how inflation evolves. The direction is clear, but the pace of change is uncertain. A quick decline in reported inflation would open the door for a reduction in policy rates, for the Federal Reserve to ease off on the brake and be mildly less restrictive.

On the other hand, a slower rate of change in consumer price index inflation sets up the ‘higher-for-longer’ narrative, very different to the ‘lower for longer’ we have experienced over the last decade. In my opinion, the balance of risks leans to the ‘higher for longer’.

The Fed wants to avoid a second surge in price pressures. It would prefer to keep its options open and be more data dependent. We’ve been hearing this a lot lately, and it is an important consideration. The challenging scenario for Fed Chair Jerome Powell is where growth slows. Inflation cools – i.e., prices stabilise or fall – but workers’ wages remain high compared to prior years.

This sets up another wave of demand pressures as consumers spend excess disposable income. The only way to avoid this scenario is to further slow the economy to a level where unemployment rises, which sounds a lot like a recession.

It appears the Fed would be willing to tolerate a drift in this direction to confirm that inflationary pressures are well contained and short-lived. The economy needs to experience a bit of pain in the labour sector to complete the job, and we’re just not there yet.

DM: Your scenario seems to lean towards a greater likelihood of some sort of recession, although its depth and length remains debatable. How do you position in the markets for the next stage of the cycle?

KO: In our base case scenario, slowing growth and falling inflation ultimately lead to lower interest rates. When market yields fall, bond prices rise. This generates a capital gain that compensates the bondholder for this elevated coupon they hold. In that sense, this is an appropriate time to lock in historically high interest rates.

It begs the question what area of the curve and what maturity range should be targeted. The shortest instruments on the yield curve are in the money market segment, with maturities measured in days or weeks. Money markets are the highest-yielding investment-grade sector at the moment, but that may not be the case for long.

At the other extreme, the long maturity segments of 10-plus years provide an opportunity to lock in yields for a long time. Unfortunately, this segment of the curve tends to be less sensitive to central bank monetary policy and therefore generates more limited gains if yields fall.

This brings us to the short-to-intermediate range which offers both attractive historical yields given the inverted curve and the potential for capital gains as yields fall. The yield curve is currently inverted, which means short-term interest rates exceed long-term ones. So on a relative value basis, the two to three-year segment offers the most attractive yields relative to longer maturity instruments and a strong sensitivity to the policy path. These are attractive features for when the Fed eventually reverses course and normalises interest rates.

Is it too early to be talking about rate cuts? We just saw the Fed raise rates. It has raised interest rates by more than five percentage points in the last 15 months, putting its foot firmly on the economic brake to slow the pace of inflation back to its 2% target.

The economy is beginning to slow. At some point, inflation pressures are likely to subside and Fed policy will no longer need to be as restrictive. The path to a more neutral rate policy would take rates from roughly 5.5% today to 2.75%. That’s a few hundred basis points of cuts just to get back to neutral.

If the economy slows much more, the Fed may have to move to a more accommodative stance that will require even lower rates. While that’s too early to forecast at this point, we believe it’s probably prudent to begin preparing for this eventuality by taking positions slightly further out on the curve and locking in interest rates for a long period of time.

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

KO: Thank you, Dan.