As investors closely monitor global signals for insights into the timing and pace of interest rate cuts, Schroders Australia suggests that the year 2024 still presents an opportune moment to secure attractive yields in fixed income.
Offering her perspective on the potential scenarios of a hard landing, soft landing, or no landing, Kellie Wood, the deputy head of fixed income at the fund manager, highlighted that bond markets have historically demonstrated resilience and strength during periods of monetary easing.
Presently, over in the US, data has indicated growth and inflation are trending lower, suggesting the Fed could lead the global easing cycle with interest rate cuts this year.
“Under such conditions, the ability of central banks to ease policy, thanks to lower inflation, is key to engineering a soft landing,” said Ms Wood.
“If we look back on previous soft landings (1987, 1995, 1998), we find that bond markets perform strongly into the first cut and well past the start of a policy easing cycle. This is even the case if there is no recession, which suggest shorter and shallower easing cycles.”
In Australia, the Reserve Bank (RBA) has observed a relatively subdued anticipation of interest rate cuts, partly attributable to the country’s inflation trailing behind other major economies. The RBA’s own projections indicate a return to the inflation target only by 2025.
“Notably, bonds markets imply an average cash rate of about 4 per cent over the next two years, only 0.35 per cent below the current cash rate,” Ms Wood said.
Given fewer rate cuts are priced into the market, Australia remains Schroders’ most favoured long duration position and it has positioned overweight investment grade bonds, particularly in Australia, in 2024.
“With the strong rally in US investment grade credit to end 2023, we prefer the Australian and European investment grade markets which offer much more appealing valuations and the potential to outperform over the near term,” Ms Wood explained.
“Our preference is to be owning Australian higher yielding assets like Australian bank sub-debt over global high yield that has also performed strongly and where valuations are now stretched.”
The fund manager indicated a preference for maintaining mid-curve exposure in Australia, particularly in high-quality spread products. This stands in contrast to their strategy in the UK, Europe, and the US, where they favour shorter tenors due to the higher yields on short-dated instruments compared to longer maturities.
Schroders opted to trim its interest rate duration position relative to the benchmark following a robust year-end rally last month. The adjustment involved moderating its long duration positions in both the US and Europe, particularly in response to market expectations that priced in over 1.75 per cent of cuts.
Additionally, Schroders increased exposure to high-quality and secure assets by investing in US agency mortgages, guaranteed by government agencies, as yields experienced a repricing in January.
But despite optimism about Australia, Ms Wood said the situation could change given the latest inflation data came in below expectations, along with soft retail sales figures and a softening labour market.
She said: “Analysis of past RBA cutting cycles also suggest the risks are skewed towards earlier cuts than the market is currently pricing.
“A key risk to this view is the stage three tax cuts that could support growth and delay the RBA easing cycle.”
According to Fidelity’s global cross asset specialist, Lukasz de Pourbaix, the macroeconomic backdrop does present a case for investing in bonds in 2024.
“Should central banks begin easing interest rates once inflation is deemed to be under control, this would be positive for bond strategies exposed to duration risk such as government bonds or strategies benchmarked against the Bloomberg Global Aggregate Bond Index,” he said.
The extent of any potential rate cuts, though, would depend on numerous factors.
“Our base case is that we are likely to experience a global cyclical recession in 2024 following a period where the market is pricing in a ‘soft landing’ scenario. Should this occur and we end up in a recession, central banks are likely to cut rates aggressively to avoid a deep recession. Such a scenario should be positive for bonds,” Mr de Pourbaix elaborated.
He also posited a silver lining for investors who remain concerned about falling bond yields ahead.
“Bond yields have remained elevated partly due to the demand/supply dynamics impacting government bonds, notably US Treasuries as issuance has increased to fund the US deficit and demand has fallen as the government’s demand for bonds has deceased following the rollback of central bank QE [quantitative easing] programs.
“We believe that this demand/supply imbalance will regulate itself with other segments of the market such as households, taking up some of the excess demand and putting downward pressure on bond yields. In the interim, bond yields may remain elevated despite inflation moderating, as this demand/supply imbalance persists.”
As demand/supply pressures and inflation ease, Mr de Pourbaix expects bond yields to fall from current levels; however, a fall in bond yields would have a positive impact on capital returns from bonds, he noted.
