Markets were repeatedly wrongfooted last year by the hawkishness of central banks.
But after a succession of interest rate pauses and a slew of soft data, hopes have risen that the Federal Reserve, the European Central Bank and the Bank of England are finally done raising interest rates.
Does that mean fixed income investors should start adding duration to their portfolios?
The upside
Sovereign yield curves have been inverted for a long time, meaning it made little sense for investors to add duration – all they would have gotten in return was more risk for less yield.
If rates have indeed peaked, investors may well now feel a natural temptation to increase duration in order to benefit from what they might consider to be the start of a steady downtrend of interest rates and bond yields.
In practice, however, it is unlikely to be this straightforward.
For one thing, less hawkish tones from central banks tend to benefit the front end of the curve most, as yields on rate-sensitive short-dated bonds fall faster than long-dated bonds, otherwise known as a ‘bull steepening’.
Moreover, in a rate cutting cycle, history shows that longer duration strategies will not necessarily outperform short-dated ones, it all depends on what happens to the yield curve.
With inflation remaining sticky, the belly and long end of the curve might not fall by as much as the market expects.
Rate cutting cycles
Look at previous BoE rate cutting cycles and it is no slam dunk that long-dated bonds will outperform.
During the 1999 rate cutting cycle, for instance, the short-dated corporate index performed in line with the all-maturity corporate index and outperformed both short-dated and all-maturity gilt indices, as front-end yields fell while long-end yields rose.
Over the long cutting cycle that started in 2001, the short-dated corporate index was up 18.8 per cent, underperforming the all-maturity corporate index by -3.5 per cent and outperforming the short-dated and all-maturity gilt indices.
Inflation could easily surprise to the upside once again.The third cycle occurred during the global financial crisis, in which sovereign yields plummeted and credit spreads widened significantly.
In this environment, the short-dated corporate index significantly outperformed the all-maturity corporate index and underperformed both short-dated and all-maturity gilt indices.
A slightly mixed picture then, reminding us it’s not a given that there will be significant benefit to adding duration in cutting cycles, particularly when the additional risk over short-dated bonds is factored in.
Higher for longer
The Fed may have skipped two rate cuts in recent meetings, but US consumers and corporates have displayed remarkable resilience.
The market has been resistant to accept the higher-for-longer narrative, but it seems unlikely that the Fed will have the confidence to cut rates until later in 2024.
If that is the case, and the Fed simply maintains the federal funds rate at between 5.25 per cent and 5.5 per cent, investors are better off at the short end of the curve as they will get better yields and more protection against the risk of further rate rises.
That risk is very real. As seen by financial conditions loosening in the aftermath of the Fed’s comments at the recent federal open market committee meeting, inflation could easily surprise to the upside once again, with the uncertain geopolitical backdrop offering few guarantees that oil prices will remain subdued or that gas prices in Europe will not drift higher as we head into winter.
If headline inflation rises again, the fear is that core inflation will follow due to second-round effects, dragging us back into a wage-price spiral. The more duration investors run in this scenario, the worse their returns may be.
In the UK and Eurozone, where growth is sluggish, the picture is slightly different.
Both regions seem more likely to slide into recession this year, and, as a result, the BoE and ECB will be less hawkish, fearful of hiking into weakness.
While we expect credit spreads to widen in 2024, these two central banks will have more room to cut rates in order to support growth, which will be a good environment for short-dated bonds.
Why not just move into cash?
Money market funds have seen significant inflows in recent months as rate rises have meant that, for the first time in a long time, they can compete for capital with other asset classes.
Their appeal is, of course, clear: we are in a high-risk environment and cash offers near riskless return.
Certainly, investors are right to want to weather-proof their portfolios, but we still believe they can achieve that aim without resorting to an asset class that has obvious limitations and a poor long-term track record relative to most risk assets.
Short-duration fixed income, after all these rate rises, has become something of a no-brainer.That said, we do not believe that equity markets right now are priced for a recessionary environment, with the equity risk premium lower than one might assume.
In a higher-for-longer rate environment, investors should expect valuations to better reflect the massive pressure under which the real economy is starting to come, with leading indicators demonstrating worrying evidence of deterioration.
But short-duration fixed income, after all these rate rises, has become something of a no-brainer.
Today, you can construct a relatively low-risk portfolio of credits and sovereign bonds yielding 6 per cent to 6.5 per cent, offering an attractive return even if the market goes nowhere.
At the short end, there is protection if rates rise and the potential for significant outperformance when rates start to fall.
And when that does happen, the return from money market funds will not be as attractive.
Nicolas Trindade is a senior portfolio manager at Axa Investment Managers
