Fixed income portfolios are likely to face a more complex and volatile environment, as the rate cycle’s turning point varies across different central banks. Market consensus suggests that while easing may begin, it will not be as rapid or deep as previously anticipated, leading to greater dispersion of returns across sovereign bond markets.
Investors are advised to adopt a more tactical approach, taking into account the potential for shorter rate cycles and the repercussions of a large US government deficit on policy management. Judging from a handful of market commentaries published ahead of central bank rate decisions this week and next, the general sentiment leans towards guarded optimism, with a focus on data and a readiness to adjust strategies in response to evolving economic indicators.
The European Central Bank (ECB) is anticipated to maintain a cautious stance on rate cuts, with no immediate policy changes expected at its upcoming policy meeting on Thursday. This approach stems from the ongoing battle against inflation and the need to balance growth prospects. The Federal Reserve’s Open Market Committee, or FOMC, provides a policy update a week later, as will the Bank of England.
Rate moves will have repercussions
Andres Sanchez Balcazar of Pictet Asset Management cautioned against over-optimism in expecting central banks to cut rates soon and deeply. These expectations have supported markets in recent months, with the yield on benchmark US and European bonds declining more than 100 basis points. Ten-year Treasuries touched 5% in October and yielded 4.13% on Tuesday. German 10-year bunds were at 2.13%, after touching 3% three months ago.
“We think those expectations are overdone,” Balcazar said in a note to investors. “Rates won’t fall as low or as quickly as the market is pricing in. This has repercussions for fixed income portfolios in particular over the coming years.”
Echoing this sentiment, Konstantin Veit from Pimco anticipates the ECB will hold policy rates steady in January, with significant insights expected in the March meeting. The market’s current prediction of aggressive rate cuts seems premature, he said, given the uncertain inflation outlook.
“We question whether the ECB will implement rate cuts as early as this due to the uncertain inflation outlook,” Veit said.
Hawkish stance expected
Monex Europe expects the ECB to maintain a hawkish stance in the near term, with the easing cycle likely beginning in April, contingent on upcoming economic data. Bank of America foresees no major policy changes in the upcoming meeting, expecting the first rate cut in June, with potential for quicker action if disinflation accelerates.
François Rimeu of La Française AM also predicts the ECB will maintain key interest rates and adopt a meeting-by-meeting approach, balancing the risks of overtightening against premature easing. This cautious stance is expected to slightly steepen the interest rate curve and moderately weaken the Euro.
“We expect that President Lagarde will continue to push back against bets on early and extensive rate cuts,” Rimeu said.
Laurent Denize and Jan Viebing of ODDO BHF suggest a preference for bonds over equities in the coming months due to higher real yields, highlighting the ongoing volatility and uncertainty in capital markets. “The expectations of interest rate cuts that underpinned the rally need to materialise before the party can really continue,” they said. “The question is not so much whether rates will be cut, but when and by how much.”
Government debt unsustainable when rates are high
The question, especially for fixed income investors, is whether the trend of falling yields that began at the end of last year will continue or come to a halt. “Interest rates are still so high by historical standards that government debt is unsustainable,” Denize and Viebing told their clients.
“One argument in favour of investing in long-dated government bonds is that they are now one of the few investments with convexity on long-term maturities, i.e., the value of the bond rises faster when interest rates fall than when they rise,” they said. “This provides some risk buffer. In our view, corporate bonds also continue to offer a good risk/return profile for both Investment Grade and High Yield.”
‘Greater dispersion’
Pictet’s Balcazar sees an additional complication. Although the rate cycle is turning for most developed markets, the pace at which different central banks will be able to cut will vary. “Together, these factors will lead to greater dispersion of returns across sovereign bond markets, more volatile interest rates and a shorter rate cycle; that in turn will force investors to take a more tactical approach to managing fixed income,” he said.
Overall, the prevailing view among experts is one of caution. The ECB is expected to proceed carefully, weighing the risks of premature rate cuts against the backdrop of an uncertain economic environment, with a keen eye on inflation and growth data. Investors are advised to temper expectations for rapid policy shifts and prepare for a more tactical approach to fixed income investments.