Jump Start: Ripple effects from the Fed pause (5:32)
A hawkish pause has sent Treasury yields up. So what’s the read through for your fixed income portfolio? Listen in.

Thought of the day

Global interest rates have moved higher across the yield curve over recent weeks, as central banks have conveyed the message that it remains too soon to declare victory against inflation. At their latest policy meetings, some central banks raised rates—including the European Central Bank, Sweden’s Riksbank, and Norway’s Norges Bank—while others—including the Federal Reserve, the Swiss National Bank, and the Bank of England—kept rates on hold. All, however, have stressed that more work may need to be done to bring inflation back to their targets and as a result, they are prepared to hold rates at (or slightly higher than) current levels for longer.

Top Fed officials, for example, now only forecast 50 basis points of easing next year, half the amount of easing they were expecting previously. As the threat of a US recession has faded, markets have also scaled back expectations for Fed rate cuts in 2024 from 150 basis points at the start of August to just 50 basis points at present.

We have long thought that the equity market has been too aggressive in pricing in rate cuts and strong economic growth, which is why we have a neutral view overall on equities. In our view, a data dependent Fed has no incentive to sound soft on inflation. But an imminent end to rate hikes and the prospect of weaker growth as rates are kept higher for longer support our preference for fixed income, and we remain most preferred on quality bonds for a number of reasons.

Regardless of whether the landing is ultimately hard or soft, US and global economic activity is set to slow over the next year. While support for growth from fiscal policy is possible in parts of the world, the magnitude of this stimulus is difficult to quantify and is highly political. We expect this to be outweighed overall by the negative impact on growth of continued restrictive monetary policy. Real rates are now positive across the curve, at levels not seen since the 2008 financial crisis. Mortgage and credit card rates are similarly at multi-decade highs. Lending standards continue to tighten. Quality bonds tend to outperform equities in periods of weaker growth.

Falling inflation should bolster the real return on fixed income, despite the recent rebound in energy prices. Consider the three components of inflation: Goods inflation, housing inflation, and core services inflation ex-housing (super-core inflation). With demand rotating away from goods and into services and global supply pressures easing, (PCE) goods inflation printed at –0.6% year-on-year in July. Housing inflation has peaked and should continue to fall. Market rents inflation has been falling steadily since the Fed started tightening policy in early 2022 and is now back to levels close to the pre-pandemic average. The official housing metric should reflect this decline with a lag.

We expect super-core inflation to continue to moderate as well. US labor markets are cooling in response to monetary tightening, if at a slow pace. We expect they will continue to do so, because the Fed is committed to bringing inflation back to target, which means it will likely maintain a restrictive policy stance until it sees further normalization in labor market conditions.

Yields remain well above long-term equilibrium levels. Our long-term yield forecasts consider three things. The first component is the real neutral policy rate (or r*). This is the theoretical interest rate at which an economy is in balance, where the economy enjoys full employment and the rate of inflation holds steady at the central bank’s medium-term target (often 2%). We cannot observe r* in market data, so there is considerable debate about its level. We use the Fed’s own forecast of around 0.5% as a best estimate. The second component of our forecasts is inflation expectations. This is the market’s expectation of average inflation rates in the future. If markets believe the Fed will reach its medium-term 2% inflation target, it’s reasonable to use 2% for this component. Adding these two parts together gives a 2.5% nominal neutral policy rate. However, market-based estimates of the nominal neutral policy rate lie well above this number, with current long-dated expectations for the overnight cash rate standing at 3.75–4%.

The third component is the term premium. This is a measure of the extra yield an investor would demand to hold a long-dated (say, 10-year US Treasury) bond rather than consecutively buying a series of shorter-dated bonds (like 1-year Treasury notes) over the same time period. Historically, the term premium has been positive—people want compensation for holding debt with a longer time to maturity. But in recent years, the term premium has been close to (or below) zero. This is the result of central bank programs like quantitative easing that look to lower long-term government debt costs by buying longer-dated bonds like Treasuries.

Major central banks are now reversing these crisis-era programs and selling their US Treasury holdings, including longer-duration debt. As such, the term premium could increase, but we don't think the Fed will allow the term premium to rise too sharply (and bond yields spike too swiftly) if that threatens market functioning or market stability. So, we think it's reasonable to forecast long-term yields under the continued assumption that the term premium is zero.

We therefore remain most preferred on high-quality bonds. Our preferred maturity is in the 5–10-year range; we see the income durability and greater scope for capital appreciation as attractive. We are less positive on emerging market and high yield bonds, given that the extra yield in these asset classes is limited for the additional risks borne.