A new regime for rates?

The following is an extract from our Q2 Active Fixed Income outlook.

In the first issue of our Active Fixed Income Outlook, we look at how the possibility of no interest rate cuts in the US would impact investors. We’ll also be looking at European credit, emerging market debt and global high yield, and outlining the current themes, risks and outlook for each of those markets.

What’s needed for a ‘no cuts’ base case?

Jay Powell and others have alluded several times to the fact that “monetary policy is too restrictive.” So, to arrive at a ‘no cuts’ base case requires them to start believing that monetary policy is no longer restrictive. Inevitably, officials will be forced to change their minds if growth continues at the current heady pace.

US annualised growth registered 4.9% in the July - September 2023 period, and a revised 3.2% annualised pace for the final three months of that year. With 2.8% growth, revised up from 2.3% for the first quarter of 2024[1] , we could now be settling into a growth environment that may negate the need for rate cuts.

Implications of ‘no cuts’ base case on yield curves and issuance

If the ‘no cuts’ theme were to become the base case, we believe that government bond yields would move higher, and curves would steepen, but it won’t just be curves that react. If market participants start to believe that the current level of interest rates is sustainable, then others will start to think the same.

For example, corporate treasurers are more likely to issue longer-dated debt today as companies seek to lock in lower coupons after several years of higher refinancing costs. We’re already seeing this play out. US corporate investment-grade (IG) supply is up 150% on the pace of the last few years, with the percentage of long-end issuance also increasing to 17% of supply, from 10% in the second half of 2023.[2]

Elsewhere, there are some investors who continue to believe that fixed income yields offer good value relative to historic levels, despite credit spreads being tight. However, those same investors may quickly change their minds if interest rates stay where they are, or even increase.

Implications of ‘no cuts’: resetting where we are in the economic cycle

Just as an inverted yield curve typically signals an impending recession, does that mean that a normalised one relays that the economy is no longer in the late-cycle stages? Or could it mean that, potentially, it’s in the early stages of a new one? It’s tempting to think that might be the case, particularly when it comes against a backdrop of surging Artificial Intelligence (AI) positivity. That said, nobody can state with any confidence how much AI will increase economic growth and the jury is still out on its exact impact.

Outlook

For now, stronger US growth and a positive backdrop for credit and equity markets is something we welcome. But, if we’re heading to a place where higher growth leads to interest rate curves normalising, coupled with the narrative of an economy that somehow manages to enjoy low unemployment, high growth and moderate inflation, then obviously we are concerned that everything is just too perfect. With markets seemingly priced for an abundance of good news, it’s not easy to see where the next headwinds may come from. But that’s not to say there won’t be any.

The above is an extract from our Q2 Active Fixed Income outlook.

[1] Source: AtlantaFed GDPNow as at 1 April 2024.

[2] Source: LGIM America as at 18 March 2024.