With most central banks presumably at highs in terms of monetary policy rates during the current cycle, the focus has rightly shifted to the timing of the first cut.
As we previously discussed, we are of the opinion that markets have moved a little bit ahead of themselves by pricing in a Fed funds rate cut in eight weeks’ time – although we do not disagree with the direction of travel and the rationale behind this. Inflation is likely to return to target eventually, while growth decelerates, and the labour market softens. All of this is in the context of a softish landing, our base case scenario.
Considering this, we think investors should start thinking about how the shape of the curve might evolve once central banks embark on the process of reducing monetary policy rates. This analysis provides interesting insights on the potential for total returns along the curve. In particular, the curve has been inverted since July 2022 if we look at the slope between two-year and 10-year Treasuries. History shows that previous episodes of inversion typically unwind via rate cuts that take the two-year lower than the 10-year, and we think this time around it will be no exception. In addition, it is worth keeping in mind that since the mid-1970s the curve has been inverted only 15% of the time.
A good starting point for this analysis is to have some notion of where we think the neutral rate of monetary policy is. Sadly, the inconvenient truth is that the answer to this very important question is that no one really knows. There seems to be some consensus (in which we partake) that the neutral rate is higher than that of the previous cycle. Back then the Fed stated repeatedly in their summary of economic projections (SEP) that their best estimate for this rate was 2.5%. It is worth remembering though that this figure was arrived at after several SEP reports that started with a “longer run Fed funds rate” projection of 4% in 2013. The cycle that took place in the aftermath of the GFC was characterised by large deleveraging of banks, governments (after an initial bout of stimulus), consumers and firms all at the same time. This is hugely disinflationary, and the effects of this were felt throughout the previous decade.
Fast forward to today and banks are in good shape, governments are running very large deficits and consumers and firms have solid balance sheets for the most part. In other words, the disinflationary forces present in the last cycle are absent, which argues for a higher neutral rate even without accounting for possible changes in supply chains due to the pandemic.
We think at the very least the neutral rate is in the region of 3% but could be higher. In the Fed’s central scenario there is no recession but only a slowdown in growth, which along with a more normalised supply environment allows for inflation to move towards the target, while the Fed starts cutting rates. In the absence of a recession, it would make sense for the Fed to cut rates until they reach neutral. There would be no reason for the curve to remain inverted in this scenario. The long-term average slope between the two-year and 10-year is just under 100 bps, which is actually pretty similar to the average slope between the Fed funds rate and the 10-year. In this scenario, if the Fed funds rate gets to 3%, it is reasonable to expect the two-year to be slightly higher and the 10-year to settle in the 3.8%-4% area. Spreads should behave well in a non-recessionary environment as default rates are likely to remain contained. We believe credit would outperform rates in this scenario, with both providing attractive returns.
There are two alternative scenarios worth considering. Firstly, inflation might take longer to normalise than the Fed expects as aggregated demand stays stubbornly strong. If this is considered to just be a delay of the scenario in the previous paragraph, then we are likely to see some volatility in the short end with less action at longer tenures. The outcome should not be too far away from that described above. Alternatively, inflation might refuse to decline towards the 2% target, calling into question how restrictive monetary policy is. This may mean that the neutral rate is actually higher than 3% and, using the same rationale as in the previous paragraph, this would translate in the 10-year settling above 4%, which would dent total returns.
The curve would remain inverted for a longer period but would eventually normalise as well via rate cuts possibly at a higher level than in the previous scenario. If the reason for the aforementioned development is a surprisingly strong economy, then spreads should not do badly. Defaults are unlikely to increase dramatically if growth is above expectations. We would expect volatility to be somewhat higher with lower total returns than in the previous scenario but with credit also outperforming Treasuries.
Secondly, we could experience a hard landing. Causes could be many but what is clearer is that Treasuries would rally as expectations build up for the Fed to take rates below their neutral level. Spreads would sell off and government bonds would outperform credit. The extent of moves would of course depend on the depth of the recession. The shape of the curve would normalise via a steep decline in the short end, with a pronounced rally at longer tenures as well, leaving the curve with a positive slope eventually.
There are a couple of relevant conclusions for asset allocation. In all scenarios above there are asset classes in fixed income that outperform cash. In the case of a softish landing the short end of the curve delivers capital gains while longer tenures deliver their yield. With no spike in defaults and no sell off in the longer end of the rates curve, credit outperforms. If inflation turns out to be more persistent, we tend to think that short-dated high-quality credit and certainly high-quality floating rate credit would outperform cash. Inflation has declined dramatically from the peaks and monetary policy rates are elevated. Given that carry is high, defaults are likely to remain contained as growth would be better than expected and the adjustment to monetary policy in this scenario would not be excessively large as the negative total return due to higher short-term rates should be more than offset by higher carry. Lastly, in the case of a hard landing it is very clear that longer dated Treasuries would outperform cash.
The other conclusion that we get from this analysis is that chances are credit (or at least certain sectors within credit) outperforms rates. The only scenario in which the opposite happens is a hard landing. Looking at Bloomberg consensus, 2024 growth forecasts have been consistently revised upwards since July 2023 in the US. In the UK, 2024 forecasts have been revised lower. But this must be read in conjunction with a steady increase in 2023 growth projections. Bloomberg consensus in January 2023 was for -0.8% growth in the UK for 2023, while the actual number is likely to be +0.5%. Something similar happened to Eurozone forecasts although we note the revisions downwards in 2024 growth have been larger from a higher starting point. In other words, the only scenario in which rates significantly outperforms credit is now deemed to be a lot less likely than only a couple of quarters ago.
Balance is key, so we are definitely not arguing against holding government bonds as they would provide protection in a non-base case scenario of a hard landing, while they give a reasonable total return in our base case scenario. But it is worth noting that the probability of rates outperforming credit has declined in line with a lower probability of a recession with an already inverted curve.