Liam O'Donnell,
Liam O’Donnell leads the Artemis fixed income team’s strategy on macro and rates. Here, he provides his thoughts on the current economic backdrop and the implications for the fixed income market.
FOR PROFESSIONAL INVESTORS AND/OR QUALIFIED INVESTORS AND/OR FINANCIAL INTERMEDIARIES ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. CAPITAL AT RISK. All financial investments involve taking risk and the value of your investment may go down as well as up. This means your investment is not guaranteed and you may not get back as much as you put in. Any income from the investment is also likely to vary and cannot be guaranteed.
1. Is the market being too optimistic about the prospect for rates to be cut in 2024? Could rates stay higher for longer?
In my view, the market may be underestimating two tail risks. One is that rates stay ‘higher for longer’. But I believe the market may also be being too optimistic in believing that global central banks will achieve a soft landing. There must be a possibility that economies have yet to see the true impact of the most aggressive rate-tightening cycle in decades.
So, while we must acknowledge that market pricing is just a probability-weighted set of outcomes, the consensus view it implies – that a ‘soft landing’ has been achieved – may be too optimistic.
Remember that, after a long period of zero interest rates, we’ve just had an interest-rate shock that saw the Fed pushing rates up by more than 5% in less than two years1. If growth does deteriorate, rates may need to be cut more aggressively than the market expects.
Fed rate cumulative change since cycle start
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Source: Bloomberg as at 4 March 2024. Market expectations are shown by a dashed line
2.Is the final mile of bringing inflation down going to be the hardest and what could that look like?
Headline measures of inflation have fallen rapidly. They could be back below central-bank targets by the middle of 2024 in the UK, EU and the US.
Admittedly, core inflation has been falling more slowly and services inflation has been sticky. I might be concerned if central banks weren’t focusing on these stickier measures of inflation – but they are.
Forward-looking survey measures of pricing pressures, meanwhile, suggest the downward trend in inflation is set to continue. So, while the final mile of bringing inflation down might take longer than some expect, I don’t think a slow glide path that brings it gradually back towards target is necessarily a bad thing.
3. Where do your views diverge most from consensus?
I see potential for growth in the UK to surprise on the upside. The UK is in a fiscally weak position – but the UK’s consumers look relatively resilient. They have faced a tighter squeeze on disposable incomes than their US counterparts over the past two years but the real income differential has now swung significantly in favour of UK households. Inflation in the UK is falling rapidly even as wage growth, although slowing, is still tracking at around 6%. So workers should feel a boost to their ‘real’ incomes this year.
Real wage growth (%change on YoY)
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Source: Lazarus Economics & Strategy/ONS as at 31 March 2024
4. Do you still expect yield curves to steepen? If so, why?
Yes. On a multi-year view, yield curves will steepen – it’s just a question of by how much.
If we look at the two-year versus 10-year area of the curve, it is inverted across the US, EU and UK. We are heading into a rate-cutting cycle. Bond supplies, meanwhile, have never been higher in net terms and will remain elevated over the years to come.
I don’t, however, believe it is necessarily a good idea to let steepening strategies dominate a bond portfolio’s risk profile – especially as most expressions of a steeper curve impose a heavily negative cost of carry. I think a steeper yield curve has become such a consensus view that the risk/reward in steepening strategies is not compelling.
Should the curve be this flat in a world without QE?
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Source: Bloomberg as at 28 February 2024
5. Which parts of the yield curve offer the best balance between risk and reward?
That’s easy. In my view, shorter-dated bonds offer a compelling balance between risk and reward. Ultimately, I believe that interest-rate cuts will dominate and that yields will move lower across the yield curve once the cutting cycle begins.
Shorter-dated bonds, meanwhile, are not influenced to the same extent as longer-dated bonds by the structural shift away from quantitative easing towards quantitative tightening.
On top of this, the supply of bonds has increased markedly from the pre-Covid levels. This should act as a headwind to longer-dated bonds relative to their short-dated counterparts. While longer-dated bonds have greater potential to deliver superior returns under a hard-landing scenario, the balance between risk and reward very much favours the short end of the curve.
1Source: Effective Federal Funds Rate - FEDERAL RESERVE BANK of NEW YORK (newyorkfed.org)
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- Emerging markets risk: Compared to more established economies, investments in emerging markets may be subject to greater volatility due to differences in generally accepted accounting principles, less governed standards or from economic or political instability. Under certain market conditions assets may be difficult to sell.
- Derivatives risk: The fund may invest in derivatives with the aim of profiting from falling (‘shorting’) as well as rising prices. Should the asset’s value vary in an unexpected way, the fund value will reduce.
- Credit risk: Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund.
- Higher-yielding bonds risk: The fund may invest in higher-yielding bonds, which may increase the risk to capital. Investing in these types of assets (which are also known as sub-investment grade bonds) can produce a higher yield but also brings an increased risk of default, which would affect the capital value of the fund.
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- Currency risk: The fund’s assets may be priced in currencies other than the fund base currency. Changes in currency exchange rates can therefore affect the fund's value.
- Bond liquidity risk: The fund holds bonds which could prove difficult to sell. As a result, the fund may have to lower the selling price, sell other investments or forego more appealing investment opportunities.
- Credit risk: Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund.
- Derivatives risk: The fund may invest extensively in derivatives with the aim of profiting from falling (‘shorting’) as well as rising prices. Should the asset’s value vary in an unexpected way, the fund value will reduce. Refer to the investment policy in fund's prospectus for further details on how derivatives may be used.
- Higher-yielding bonds risk: The fund may invest in higher-yielding bonds, which may increase the risk to capital. Investing in these types of assets (which are also known as sub-investment grade bonds) can produce a higher yield but also brings an increased risk of default, which would affect the capital value of the fund.
- Emerging markets risk: Compared to more established economies, investments in emerging markets may be subject to greater volatility due to differences in generally accepted accounting principles, less governed standards or from economic or political instability. Under certain market conditions assets may be difficult to sell.
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