In our latest podcast, Head of Global Macro Strategy Paul Mielczarski talks to Senior Vice President – Investment Specialist Katie Klingensmith about how the macroeconomic outlook is influencing fixed income positioning. A summary of their conversation is included below. For the full discussion, listen to the podcast or download the transcript.
How likely is a soft landing for the U.S. economy?
On the inflation front, we are quite confident that the Federal Reserve (Fed) will be able to reach its 2% target. We are seeing goods prices falling, and we expect lower rental inflation in the CPI data and softer service inflation—outside of rents—as labor markets normalize. The growth outlook is a bit more uncertain. Despite its resilience over the past two years, the U.S. faces some significant headwinds. First, higher rates are being gradually passed on to consumer and business borrowing costs. Second, fiscal policy is likely to be less supportive in 2024. Lastly, areas like bank lending growth and commercial real estate remain weak. At the same time, there are some important sources of economic resilience that are likely to remain in place. Labor supply and productivity growth have been very strong, allowing inflation to normalize without a recession. With real consumer incomes likely to be supported by decent nominal wage growth and falling inflation, it is difficult to see what would cause a sudden slowdown in the economy. Furthermore, significant easing in financial conditions should boost housing and business investment. Overall, the U.S. economic trajectory seems headed for a soft landing. However, this outcome is already largely reflected in current market expectations.
What do we expect to see in the Treasury yield curve?
Markets are already pricing in significant rate cuts, but it is hard to envision the Fed delivering more without a recession. Without a recession or major growth scare, the U.S. 10-year yield may remain rangebound somewhere between 3.5% to 4.5%. With inflation falling sharply and major developed market central banks about to embark on rate-cutting cycles, we believe the overall environment is favorable for bonds. An environment in which the Fed eases as inflation is coming down and growth remains good should reinforce the expectation of an economic soft landing and steeper yield curve. We do believe the U.S. economy is ultimately going back toward an equilibrium of around 2% real gross domestic product (GDP) growth and 2% inflation, but we do not necessarily think that the interest rate structure will return to pre-pandemic levels. For example, from the start of 2010 until the end of 2019, U.S. nominal GDP growth grew by around 4%, roughly a 2% real growth and 2% inflation trend. But during that entire 10-year period, policy rates averaged only around 60 basis points, and 10-year yields were only around 2%. Going forward, we would expect nominal GDP growth of 4% to be roughly consistent with a 3% to 3.5% average federal funds policy rate and approximately a 4% to 4.5% 10-year bond yield.
How may quantitative tightening impact the curve?
Ultimately, the Fed wants to ensure that the balance sheet runoff does not create major distortions and dislocations in the short-term funding markets. The latest signals from the Fed suggest the balance sheet runoff could happen soon, perhaps finishing around the third quarter. However, while the Fed’s balance sheet management may be somewhat supportive for fixed income, it is unlikely to have a meaningful impact.
Will the concept of term premium impact the U.S. Treasury environment?
Last November, the Treasury refunding plan reduced issuance at the long end of the curve, which helped to compress term premiums in the short term. However, this relief is likely to be temporary because it will be the trajectory of the U.S. deficit that will drive the medium-term bond supply outlook. Rising bond supply may have a more direct impact on term premium and on swap spreads. Over the past two years, 10-year Treasuries have cheapened versus swaps by around 15 to 20 basis points, due in large part to rising Treasury supply. We expect this trend of U.S. Treasury underperformance versus swaps to continue over the next several years in response to growing supply and very elevated fiscal deficits.
How is the team thinking about duration?
We generally have been overweight duration in the U.S. and U.K. while underweight duration in the eurozone and Japan, driven in part by relative interest rate spreads but also to reflect the role of more aggressive fiscal stimulus in recent U.S. economic outperformance. As this impact of fiscal stimulus starts to reverse, we would expect to see some convergence in relative growth between the different regions.
Another market on which we are focusing is Japan. We do believe there has been a structural regime change in Japanese inflation trends, and we expect the Bank of Japan will hike rates sometime in the second quarter or even potentially in March for the first time in 17 years. Over the next one to two years, we could see Japanese policy rates potentially rising toward 50 basis points to 1%, and Japanese rate markets do not appear to be priced for this regime change.
Two other fixed income areas we also find attractive are select emerging market government bonds and agency mortgage-backed securities (MBS). For example, Mexican government bonds offer attractive nominal and real yields, both in absolute terms and relative to Treasuries. U.S. agency MBS spreads versus Treasuries are still very attractive from a historical perspective and relative to investment grade bonds where spreads are generally quite tight. Furthermore, agency MBS tend to do well in periods of lower interest rate volatility, like the rangebound environment described previously.
How are you thinking about the U.S. elections at this juncture?
What will matter is not just which party wins the White House, but who will control the Congress as well. If one party controls both seats of power, that would increase the risk of even wider fiscal deficits than we are projecting today. It also may potentially lead to somewhat higher term premiums and somewhat higher long-end rates. The possibility of additional tariff barriers could potentially put a number of both emerging market and developed market economies at risk in terms of growth and may boost inflation in the short term, reversing some of the progress seen on inflation in recent months. The opportunity to elect a new Fed board chair in 2026 will shape the central bank’s leadership with potentially significant implications for U.S. bond yields and the dollar.
How would you summarize the key takeaways regarding duration?
We are likely to go through a period of bond market consolidation in 2024. With U.S. 10-year yields potentially trading sideways for some time, in our view, more interesting opportunities could come from relative curve and cross-country positions. For example, we see attractive, relative opportunities in U.K. duration; select emerging markets, particularly in Latin America; and U.S. agency MBS. We generally expect the U.S. yield curve to steepen in either a soft landing or recession scenario, leading us to favor positioning in the short end to the intermediate part of the curve. From an asset allocation perspective, there is also a compelling case for U.S. bonds versus equities.
Press play below to listen to the full commentary.
Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.