Fixed income policy week takeaways

The Fed and Other Global Highlights

In a move that many Wall Street economists missed in terms of scale, the Federal Reserve cut its policy rate by 50 basis points (bps) on September 18, its first ease in four years. Interestingly, according to John Authers of Bloomberg, in the wake of the Fed’s decision, when Fed Chair Powell was asked if not cutting in July was a mistake, he admitted that the Fed would in fact have moved then if it had access to June’s surprisingly benign inflation numbers that were published shortly after the central bank’s last meeting. Through this lens, Wednesday’s 50 bps move can be viewed as a “catch up” and not indicative of a Fed that just pulled an “economic fire alarm.”

In terms of what’s next, T. Rowe Price economist Blerina Uruci, who had projected the Fed cutting 50 bps this week, expects two more 25 bps moves from the Fed before year-end. In aggregate, she expects the Fed to cut 125 bps to 150 bps over the next 12 months in 25 bp increments, which stands in contrast to the market that is looking for approximately 250 bps in total cuts over the same time horizon. 

So far, U.S. equity markets have welcomed this Fed action and guidance that came with it as the S&P 500 advanced following the Fed rate cut. However, the U.S. Treasury yield curve, which had already rallied sharply since last April, has shrugged off the news. Consider the 10-year U.S. Treasury yield, which notably rallied since late April to September 16 but trended higher during the week of the Fed meeting. This seeming U.S. Treasury yield curve indifference is consistent with the beliefs of the firm’s Fixed Income Division, which expects the reaction function in intermediate- to long-maturity U.S. Treasuries to this Fed easing cycle to be unique relative to history. In other words, it may be that the U.S. Treasury yield curve returns to its more normal positive slope across its term structure by having intermediate to longer maturities remain at current to higher levels as the Fed sets forth on the easing path described above. Supportive of this view is the understanding that this Fed cut is proactive relative to a softening U.S. labor market but not reactive to a broken U.S. economy. In addition, the team is also cognizant that the market will need to absorb considerable U.S. Treasury coupon supply next year to support U.S. deficit spending and fiscal policy largesse while also being mindful of shifting global macroeconomics.

Global Economic Considerations

Away from the U.S., eurozone policymakers face a quandary as services inflation is running beyond target while the central bank has begun an easing campaign to address weakness in its manufacturing sector that arguably ties into economic malaise in China. With regard to China’s economy, economic data, driven by a collapse in China’s residential property sector, continue to disappoint. Income, consumption, and construction all continue to soften, while policy continues to respond with incremental steps seemingly intended to prevent a larger drawdown in its struggling economy. An additional observation of interest comes from Latin America, which reinforces the conservative viewpoints on where our Fixed Income Division expects domestic rates to go from here, articulated above. To this end, it is interesting to note that Brazil’s central bank, which has been running almost a year ahead of the Fed throughout the post-pandemic global rate cycle, just raised its policy rate 25 bps to 10.75% after cutting this same rate from its recent peak of 13.75%.

Bottom Line—From our perspective, T. Rowe Price offers a full suite of fixed income products for investors looking to move out of cash and into short duration credit or intermediate/core and global multi-sector fixed income. Meanwhile, the absolute yields now offered by domestic and global high yield, which are now also economically supported by the Fed, warrant strong consideration in our view.

Through a disciplined investment process, anchored by its policy week in conjunction with expanding quantitative capabilities and its ongoing global bottom-up research effort, the T. Rowe Price Fixed Income Division is qualified to actively manage the array of strategies that compose its investment platform through an investment environment that looks to be volatile in the weeks and months ahead. 

Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments.

Sahm, Sahm but different: Why the breach of the Sahm rule doesn't mean the U.S. is in recession

The Sahm recession indicator (the Sahm rule), one of the most accurate leading indicators of every U.S. recession since the early 1970s, had already been trending in recent months and became a market focus after the most recent non-farm payrolls data release. While breaching the Sahm rule, based on history, can be interpreted to mean that the U.S. economy is nearing or already entered recession, the T. Rowe Price Fixed Income Division thinks this time is different. Here’s why. 

What is the Sahm rule?

The Sahm recession indicator signals the start of a recession when the three-month moving average of the national unemployment rate (UR) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months. 

The details of the July breach tell a different story

While this value of 50 basis points (bps) was met with the July data when the UR rose to 4.3%, there are some reasons that support that this may not mean that the U.S. is entering or has entered recession, such as:

• The details of the July labour report suggest that the labour market is not as soft as suggested by the headline numbers. In particular, the UR increase was mainly driven by a rise in labour force participation, an increase in the number of people that were not able to work due to bad weather, and rising temporary layoffs, with the caveat that those individuals could be called back into work over the next few months. Permanent layoffs, meanwhile, remained modest.
  
  
• Importantly, the National Bureau of Economic Research (NBER) is the final arbiter on whether the U.S. economy has entered an economic recession. The NBER evaluates a range of indicators, including real disposable income growth, real consumer spending, industrial production, and the unemployment rate, which all moved in the same direction prior to the last three recessions that occurred after a triggering of the Sahm rule. In contrast to this historical analysis, during the past three months, only household employment data has been soft, while the other indicators remained expansionary.
  
  
• While this time may be different for a breach of the Sahm rule, it didn’t prevent markets from fiercely overreacting, in our view, when this negative data point for the world’s primary economy almost immediately followed the Bank of Japan’s historic 25 bps policy hike on 31 July 2024. As a result, August’s generally illiquid summer market had to immediately grapple with the synchronous prospect of higher policy rates in Japan and potentially sharply lower policy rates in the U.S. (materially driving both currencies forcefully in different directions), which, in combination, represented a form of a margin call for a yen carry trade that had grown in seismic scale since the end of 2022. Interestingly, while this global capital market tumult followed the triggering of the Sahm rule, when much of the yen carry trade quickly unwound, capital markets have not only largely stabilised but also have mostly recovered what was lost during this recent market shock.

Fed rate cuts could lend support 

Beyond the Sahm rule, we also recognise that recent decelerating trends in inflation and employment growth have also opened the door for the US Federal Reserve (Fed) to start easing monetary policy (helping extend the economic cycle), but just not at as fast a pace as the market quickly priced, which was part of the phenomenon that sparked the global carry trade unwind referenced above.

T. Rowe Price’s Chief U.S. Economist Blerina Uruci currently expects up to three rate cuts from the Fed before year-end if inflation and labour markets continue to cool. To the extent that this view matches prospective Fed action, the current state of the economy and markets appear to be in a mid-cycle adjustment where the Fed may cut rates in 25 bps point increments four to five times in aggregate (including the three rate cuts mentioned above). Such a move would help extend the fundamentally sound condition of the U.S. economy, which remains resilient in our view.

Bottom line 

While the technical catalysts that drove the sharp capital market unrest described above look to have now largely played themselves out, additional volatility, driven by other considerations such as geopolitical and U.S. election uncertainty, appears likely in autumn. There is a silver lining, however, as increased volatility helps make a case for active management in fixed income from the following three perspectives:

• A normalising U.S. Treasury yield curve – While the normal shape of the U.S. Treasury yield curve is upward sloping as it appropriately discounts the time value of money, the U.S. Treasury yield curve has been far from normal and inverted since July 2022. With the Fed now in play for September and driving yields down in the front end of the Treasury yield curve in the process, “curve steepening” strategies represent an opportunity for active fixed income managers to position ahead of a return to a normally shaped U.S. Treasury yield curve.
  
  
• A resilient U.S. economy is supportive of credit – While spreads remain historically tight across the quality spectrum, credit fundamentals that have been sound appear poised to remain so in our view. More importantly, credit markets remained open during the recent market distress, which signals a diminished probability that hidden technical pressures exist across global credit markets.
  
  
• U.S. Treasury yields plunged during last week’s market upheaval – Increased market volatility and dramatic swings in U.S. Treasury yields can create opportunities for fixed income managers who can tactically adjust duration exposures. T. Rowe Price Fixed Income Teams took the opportunity to shorten duration in select strategies when the 10-year U.S. Treasury yield overshot (in our view) downward to the 3.7% range—now closer to 3.9% as of 12 August—particularly relative to heavy U.S. Treasury supply still to come.

From a more holistic perspective, meanwhile, the move out of cash and into short duration—the T. Rowe Price team has been presciently long duration within the front end of the yield curve— now warrants additional consideration with the next Fed communications coming in the form of a “live” September meeting. Beyond a small step into short duration, the next larger move into intermediate/core fixed (as well as global fixed income) becomes a light at the end of the tunnel that suddenly approaches with a now quickly normalising Treasury yield curve.

Through a disciplined investment process in conjunction with expanding quantitative capabilities and its ongoing global bottom-up research effort, the T. Rowe Price Fixed Income Division is qualified to actively manage through an investment environment that looks to be volatile in the weeks and months ahead.

Rate cuts could come sooner than you think

The T. Rowe Price Fixed Income team expects the Federal Reserve (‘Fed’) to deliver a 25-basis point (bps) rate cut at its September meeting, with the probability rising for more easing before year-end. Amid a myriad of variables evaluated to assess potential future Fed action, recent favourable trends in ‘sticky’ and elevated Owners’ Equivalent Rent (OER) as well as transportation costs (airfare, hotel prices, and used cars) emerged as key drivers for falling inflation. Decelerating wage pressure in recent months (see Fig. 1), combined with a slower-growing US economy, also opens the door to a rate cut in September, in our view.

The resilient yet softening US economy

The US economy is bent from the US Federal Reserve’s (‘Fed’) higher for longer monetary policy, but it’s not broken. The once ‘white hot’ housing market during the pandemic has slowed under the weight of 7% mortgage rates. Importantly, this helps reduce the sharply elevated OER, one of the most important components embedded within domestic inflation levels today. Beyond decelerating OER, a strong domestic labour market is now also showing signs of softening, evidenced by slowing wages.

Against this backdrop, the Fed’s preferred inflation gauge, Personal Consumption Expenditure (PCE), reached 2.6% in its May release. These considerations, along with anticipation of a US economy growing in the 1.5% range (per the JP Morgan Smoothed US GDP Nowcast) instead of its 3% pace a year ago, again put the Fed in a position to act in September from our perspective.

The uncertain path ahead

While inflation is moving in the right direction, its future remains uncertain. Between a trade war started in 2016, the pandemic, and heightened geopolitical uncertainty, today’s world is less globalised and arguably more inflationary than the one left in late 2019. With pandemic-related distortions finally working their way out of the financial system, global fragmentation concerns now arguably become more important.

Consider the deflationary trend in core good prices during the past year, which we now see as a contributor to inflation going forward. Interestingly, we also see the most recent fall in airline fares and hotel prices as one-off contributors to deflation. More importantly, the acknowledgment that the sharp recent drop in OER, which ties into a softer US housing market, appears likely to either fall at a decelerating pace or stabilise from here as overall housing supply scarcity remains a price support for the sector overall.

A measured view on future Fed action

In light of the balanced perspective referenced above, T. Rowe Price Fixed Income team maintains a more measured view on future Fed action compared to the market, which now expects approximately seven rate cuts from the Fed over the next four to five quarters. For now, we expect a 25-bps rate cut from the Fed in September while acknowledging a growing probability that more Fed action may follow before year-end.

Strategic focus amid rate cuts

Through the lens described above, the T. Rowe Price Fixed Income team is focused on portions of the market that we believe offer convexity (such as select securitised credit), which can participate in market upside while importantly limiting the downside of higher rates; a risk that is largely being ignored by the market at this time. At the strategy level, with the Fed now poised to move, we believe short-duration strategies take on heightened importance while emerging market debt looks to benefit from a less strong US dollar that, in our view, looks to weaken near term with Fed action coming. With the exception of some near-term weakness in select regions within emerging market debt, we believe credit markets and related strategies remain wide open overall.

Bottom line

Through our disciplined investment process, in conjunction with expanding quantitative capabilities and our ongoing global bottom-up research effort, the T. Rowe Price Fixed Income team is uniquely qualified to actively manage an array of strategies through an investment environment that we believe will be volatile in the weeks and months ahead.

Aggressive fiscal policy and an AI "arms race"

Powered by aggressive fiscal policy and an AI "arms race" driving elevated capex spending, a resilient US continues to drive the global economy but now has some help from Europe.  With an industrial oriented economy that never fully recovered from the economic impact of the pandemic, Europe is now experiencing not only a near term pickup in manufacturing momentum but is also achieving recovery within its services sector.  And while China has experienced an epic property collapse that has weighed on its consumer base, it has also shifted its economic focus toward industrial production and is flooding the global economy with cheap exports such as electric vehicles and solar panels in the process.  As a result, China doesn’t represent a drag on global growth, but, importantly, has represented a deflationary pulse that has helped ease inflationary pressures more globally. 

Against this backdrop, the following highlights emerged:    

• Overall Global Growth – Relative to a scale that evaluates markets and issuers at a most constructive level of 1 to a nadir of 5, our Fixed Income division sees the global economy operating at a level of “2” into the Australian spring. 
• Inflation and the US Federal Reserve – Inflation in the US remains elevated, sticky but is still gradually moving in the right direction as Core CPI is expected to decrease from its current level of 3.4% to the 2.8% range by next Australian Autumn.  And while still elevated, US monetary policy, at its current level, is still restrictive and the Fed does not want to induce a recession by being late to ease.  Against this backdrop, the T. Rowe Price Fixed Income division expects one 25 basis points cut from the Fed before year end which is aligned with current Fed guidance while other market participants expect as many as 300 basis points of cuts by next Australian Autumn.   
• Risk assets remain supported – The macroeconomic landscape described above remains constructive for risk assets.  And with a connection to vibrant private credit markets as well as a price discount that bolsters an already attractive “surface” yield for the asset class, Bank Loans remain a high conviction sector for the division. Based on valuation as well as potential diversification benefits they provide, the Securitised sector and higher quality portions of Collateralised Loan Obligations also represent heightened value.   

Sovereign risk and a wide near-term range for US Yields

James Carville, a political adviser to the Clinton administration, once quipped that if there was reincarnation, he aspired to come back as the bond market so he could intimidate everybody.  Carville was of course referring to so-called bond market vigilantes who sell the bonds of fiscally irresponsible sovereigns to drive up their yields as a stratagem to alter their behavior.  And while bond market vigilantes haven’t been heard from much since the 1990’s, they have emerged in recent years as a force to consider. 

Former British Prime Minister painfully found out about such vigilantes in the fall of 2022 when they arguably forced her out of office in just 44 days after Liz Truss put forth a disastrous “mini budget” that spooked markets and drove yields up while also negatively impacting the Pound.  Similar dynamics are taking place in France right now as President Macron’s snap election has roiled France’s bond market as strong showings from far right and left wing parties have exacerbated general concerns for fiscal sustainability in France.  

For right now, with the exception of certain moments last fall, the US has generally been immune to such negative action in its Treasury market despite its burgeoning national debt and wide annual deficits.  And while this largely stems from the US hosting the world’s reserve currency in addition to boasting a bond market that is hard to replicate in terms of its scale and ease of use, the sobering reality that fiscal prudence will not likely be returning to the US anytime soon is one reason why T. Rowe Price Fixed Income division expects the 10 Year US Treasury to trade within a range of 4.00% to potentially 4.75% for the foreseeable future even with a potential Fed rate cut this year.