Will the U.S. Federal Reserve loosen its monetary policy as expected?
Interest-rate cuts from the U.S. Federal Reserve (Fed) are likely to be seen in 2024 and our expectation is for the FOMC to begin during the summer months. Nevertheless, ambiguity remains on the pace and depth of the impending easing cycle. Futures contract pricing tied to future Fed policy continues to oscillate on policymaker communication and incoming data, but the ultimate future path depends largely on the evolution of inflation and economic activity.
While an active bond manager doesn’t necessarily need rate cuts to generate strong long-term returns, our goal is to explore the current opportunity in fixed income in the context of our base case scenario. If inflation doesn’t allow the Fed to meet market expectations, we expect a scenario of higher-for-longer rates to have a substantial impact on real economies and the performance of global financial markets. While likely acting as a drag on economic activity, persistently higher interest rates offer a silver lining for fixed-income investors in restoring the traditional role bonds play in an investment portfolio. As such, for investors with a longer time horizon, we would argue the future path of interest rates matters less than some investors think.
In the current environment, characterized by a protracted period of high interest-rate volatility, we believe active, opportunistic fixed-income strategies are best suited to embrace the potential subsequent market dislocations. Among other long-standing investment benefits of a flexible strategy, favoring one that also takes a global approach offers the potential for relative yield opportunities and added diversification for portfolios. Country selection, as well as yield curve positioning, comes with increased importance when looking outside domestic markets; each one comes with unique monetary policy regimes in addition to different sovereign, political, and liquidity risks investors must consider.
Navigating volatility with broader geographical exposure
There’s a motto in financial markets that says, “Don’t bet against the Fed,” but given this unique interest-rate environment, what we would much rather say is rate volatility is too elevated “to only bet on the Fed.”
Prospects for rate cuts and slower growth across many global economies have created new opportunities across many segments of fixed income; however, like any economic forecast, the future remains uncertain. This is why fixed-income investors need to be flexible.
With global central banks at different stages in their monetary policy cycles, a tactical approach to managing interest-rate risk is crucial to navigating the uncertainties, and subsequent volatility, that lies ahead. Currently, we're finding pockets of value across global interest rates from a risk/reward perspective where we believe local central banks could lead the Fed in terms of easing monetary policy or where markets aren't yet expecting a dovish turn in policy over the next year.
Despite this, as markets contend with elevated interest-rate volatility, we believe investors should take care not to overextend duration and/or risk positioning with the path of longer-term inflation and neutral rates of interest unclear. For instance, taking on ultra-long duration has the potential to result in unnecessary high amounts of mark-to-market price fluctuations; rather, we prefer balancing duration risks with sufficient levels of yield to help offset potential price losses in the short term.
U.S. long-term bonds have been consistently more volatile than stocks since last year
U.S. long-term Treasuries vs. U.S. large caps, 90-day volatility
Source: Manulife Investment Management, Bloomberg, as of January 31, 2024. U.S. long-term Treasuries are represented by the Bloomberg U.S. Long Treasury Total Return Index. U.S. large caps are represented by the S&P 500 Index. It is not possible to invest directly in an index.
Looking globally for example, with the eurozone seemingly transitioning from one of stagflation to more of a recessionary backdrop, we believe the European Central Bank will likely have room to cut first. Conversely, Australia and New Zealand are two markets where monetary policy and recent central bank comments have been more hawkish than the Fed and the market consensus expects a later pivot toward easing. This dynamic has helped keep rates higher in these jurisdictions and has paved the way for new investment opportunities due to the relative yield pickup locally.
To be clear, we like where U.S. interest rates stand and are headed, but when significant monetary changes are expected and rate volatility is as high as today, we prefer to mitigate our duration positioning by geographically diversifying our duration exposure.
Not all duration is created equal
The last few years have been extremely challenging for central banks around the world. Notably, the COVID-19 pandemic rattled the global economy and supply chains; extraordinary global fiscal policy support and the Russia-Ukraine conflict fueled already-elevated inflationary pressures; and a number of U.S. regional bank failures shook the global bank ecosystem. In addition to these major events, each central bank has had its own economic reality to deal with, creating particularly large monetary policy divergences across countries—and opportunities for active managers to add value.
In recent years, several emerging-market central banks were fast to respond to inflationary pressures. Banco Central do Brasil, Brazil’s central bank, was among the most aggressive central banks to hike rates in the aftermath of the COVID-19 pandemic. In this case, the central bank was also among the first to pivot from monetary tightening to easing as domestic inflation pressures cooled dramatically.
Mexico’s central bank, Banxico, also urgently hiked interest rates during this period. Although the central bank has remained on hold for close to a year, with an overnight rate of over 11%, Banxico has plenty of room to cut interest rates when the time comes.
Some central banks have already started easing
Key rate of selected central banks
Source: Manulife Investment Management, Bloomberg, as of January 31, 2024.
By contrast, Japan is one of the only countries without a need for aggressively tighter monetary policy due to a lack of persistently high inflationary pressures. For decades, its inflation rate had been well below that of its developed-market peers, and when inflation surged to double digits in many regions, Japan’s inflation remained relatively subdued. This allowed the Bank of Japan to keep its ultra-loose monetary policy and its key rate unchanged at -0.1% throughout the global rate hike cycle. As a result, Japan’s bonds have outperformed over the last couple of years, but its interest-rate risk/reward profile is now much less attractive relative to other developed countries. As such, we’ve limited duration exposure to that country for the moment.
China is another country where we think investors aren’t being compensated for risk from an interest-rate standpoint. While yields in most countries have sharply rebounded since reaching all-time lows during the COVID-19 pandemic, the rebound in Chinese yields has been short-lived. Concerns over slowing growth, notably, have recently pushed rates to new all-time lows. At this point, we believe the chances of seeing significantly lower yields in China are slim—its economy, though slowing, is still relatively resilient.
Despite both markets lacking attractive valuations, Japan and China are large components of the global government bond market. In fact, more than a third of the Bloomberg Global Treasury Index’s duration exposure comes from Japanese and Chinese government bonds. So while the index’s duration of about 7.5 years can look attractive on the surface—as yields may come down globally—a big chunk of that duration doesn’t have, in our view, a risk/return profile that investors should look for when trying to benefit from a decrease in global yields.
Passive global government bond investors’ duration is heavily exposed to Japan and China
Duration contribution, per country
Source: Manulife Investment Management, Bloomberg, as of January 31, 2024. Global government bonds are represented by the Bloomberg Global Treasury Index, which tracks fixed-rate local currency government debt of investment-grade countries. It is not possible to invest directly in an index.
When building a fixed-income strategy, it should be noted there are other areas of risk to consider outside of interest rates, including risk elements such as credit risk, currency risk, and liquidity risk. In the instance of Brazil, with sub-investment-grade credit ratings, the country has a higher amount of credit risk compared with developed markets and some emerging markets. With Japan, we're able to take a view on the Japanese yen while owning short-term bonds. Hedged yields currently offer over a 5% yield with the added flexibility to embrace currency risk by unhedging the position when appropriate.
When we increase our duration, the goal is usually to add yield or total return potential when expecting interest rates to fall. Selecting the right regions and the right bonds is therefore key to getting duration exposure that is aligned with that view.
Embracing duration with global exposure
In the current macroeconomic environment, where slowing growth and cooling inflation are conducive to monetary easing, we're finding opportunities to tactically embrace interest-rate risk. Over the last few years, yields rose across almost all developed fixed-income markets and now exceed decade-long averages. As such, bond investors with medium-to-longer-term time horizons can now benefit from stronger potential returns from higher interest rates without the need for interest-rate cuts.
10-year government yields across several developed markets
Including historical ranges, along with median and current yields
Source: Manulife Investment Management, Bloomberg, as of December 31, 2023. This is a box and whisker plot. The lines on the chart represent the range that yields for each country’s 10-year government bonds have settled from December 31, 2013, to December 31, 2023. Each country's range is divided in quartiles, with each box representing the range that yields have traded within half of the time, also known as the interquartile range, and with the line splitting each box representing the median. Each dot represents the yield for each country’s 10-year bond as of December 31, 2023.
But with fixed-income volatility remaining near the highs, managing interest-rate risk in 2024 isn’t just a matter of short versus long duration. Active fixed-income managers should be prepared for alternate scenarios. In the event of a higher-for-longer rate environment, it’s important to remember that higher yields bring attractive income and return potential while also defending against potential price losses. In the instance, economic conditions deteriorate faster than expected or markets are affected by external events, price appreciation offers strong upside potential for fixed-income investors, and bonds could act as a buffer for equity markets or other riskier allocations within a portfolio.
Regardless of the path, right now is a historically unique time for fixed-income investing. We believe geographical diversification and diligently selecting where that duration comes from will be particularly important as bond investors look to generate strong risk-adjusted returns.
Important Disclosures
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
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