As investors grapple with the potential market impact of the upcoming U.S. presidential election and simmering geopolitical tensions, Greg Peters, co-chief investment officer of PGIM Fixed Income, is closely monitoring a unique set of derivatives to gauge the Federal Reserve’s future policy path.
Peters, who is based in Newark, New Jersey, is one of the co-heads on the multi-sector team and co-cio at PGIM Fixed Income. Prior to joining the firm in 2014, he was Morgan Stanley’s chief global cross asset strategist, responsible for the firm’s macro research and asset allocation strategy. Earlier in his career, Peters worked at Salomon Smith Barney and the U.S. Department of Treasury.
Speaking to Investment Officer during a recent visit to Amsterdam, Peters revealed that he and his team closely analyse the options market for the Secured Overnight Financing Rate (SOFR) futures contract as a key benchmark for short-term interest rate expectations. By examining the probabilities embedded in the options’ pricing, Peters said PGIM can get a more nuanced view of where the market sees Fed policy heading.
Tail of distribution
“What we really focus on internally is the tail of the distribution of what investors are pricing in the SOFR future options,” Peters explained. “It gives you a probabilistic sense, instead of just a single number.”
That SOFR futures data, according to Peters, reflects how quickly market expectations can shift as probabilities for interest rate scenarios have swung significantly throughout the year.
In January, the chance of the Fed maintaining a restrictive rate of 4 percent or higher was just 30 percent. A series of strong inflation numbers pushed that probability to 70 percent before it fell to 10 percent ahead of a recent market sell-off, only to rebound to 30 percent. Peters said that this volatility underscores the unpredictability of the market, with the likelihood of a highly accommodative Fed stance dropping sharply from 29 percent at the end of September to just 16 percent last week, as expectations have again shifted towards higher rates.
‘Varying degrees of bad’
This real-time tracking of market expectations is particularly crucial given the high degree of uncertainty surrounding the U.S. political landscape and global geopolitical developments. With polls suggesting a tight race between President Donald Trump and his Democratic challenger Kamala Harris, investors are grappling with the potential implications for fiscal and trade policy.
“If Trump gets elected, I think that is a trend that stays in place” for a steeper Treasury yield curve, Peters said, referring to Trump’s more inflationary policy agenda. However, he acknowledged that even a Harris victory may not necessarily reverse that dynamic, as the Democrat’s own spending plans are “not like they’re fully constrained”.“It’s really a matter of varying degrees of bad.”
Scenario-based approach to geopolitics
Navigating this fluid political environment requires a flexible, scenario-based approach, according to Peters. PGIM has bolstered its in-house geopolitical analysis capabilities, bringing in subject matter experts to help assess the potential market impacts of various election outcomes and other global flashpoints.
The importance of geopolitical factors in financial markets has also been highlighted by the International Monetary Fund (IMF) in its latest meetings. The IMF emphasised that geopolitical uncertainty is an underrecognized source of risk for global financial markets, something that Peters and his team at PGIM have been closely monitoring.
“Thinking through the various contours of a conflict or a geopolitical flare-up, we do it through a scenario-based probabilistic way,” Peters said. This approach has become increasingly important, as evidenced by the recent development of North Korea committing to send three thousand* to Ukraine, which Peters described as an “incredibly important” escalation that “changes the whole catalyst of the conflict.”
Typically, in financial markets—especially fixed income—rate cuts by central banks tend to suppress market volatility. But that hasn’t happened this time. For Peters, that’s a warning sign. “To me that’s somewhat of a canary in a coal mine, just highlighting that this fraught geopolitical slash political environment just naturally translates into a higher volatility regime, and that’s exactly what we’re in.”
*Editor’s note: Following the interview, the US Pentagon released a significantly higher estimate on how many soldiers North Korea will send to Russia/Ukraine in the coming weeks. These are not expected to be three thousand, but ten thousand, the US Department of Defence said on Monday.
Further reading on Investment Officer Luxembourg:
- ‘Comrade Kamala‘s’ economic plans get lukewarm reception
- Trump seeks more control over interest rates if re-elected
- US cut lures investors, but best opportunities may be short-lived