Q&A: The macroeconomic outlook for fixed income

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.

“Economies have yet to feel the full impact of the most aggressive rate-tightening cycle in decades…”

Fed rate cumulative change since cycle start

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.  

“One reason why UK economic growth be stronger than expected: consumers are seeing a boost to their ‘real’ incomes as wage growth beats inflation…”

Real wage growth (%change on YoY)

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?

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.