Racing to ease

Global bond markets are racing to price in more easing as central banks show greater willingness to cut policy rates. The months of shifting narratives about if and when the US Fed would cut policy rates and, more recently, whether by 25bp or 50bp, are over. In its September meeting, the Fed kicked off its cutting cycle, lowering the policy rate by 50bp. While it still sees the economy as healthy and the labour market as solid, it was time to recalibrate policy: inflation risks have come down while risks to the labour market have risen. The 50bp cut signals (1) the Fed's commitment to stay ahead of the curve (or at least not fall behind it) and (2) confidence in the Fed's progress on moving inflation toward the 2% goal.

Unlike the typical cutting cycle, these cuts are coming while economic growth is decelerating but still healthy. The US economy expanded by 3.0% in the second quarter, and growth looks to be tracking at a solid 2.0% annualised pace for Q3. The cuts do not aim to stimulate the economy but to acknowledge progress on inflation and move toward a normalised policy stance. Given the Fed’s confidence in the inflation path, not cutting now would mean restraining the economy further via higher real interest rates. Hence, this cut reflects growing faith in a soft landing. Further, the size of the cut shows the Fed’s willingness to go big in response to weaker data, especially in labour markets. It’s the path of labour demand that will be important in determining the pace of cuts ahead.

Since the beginning of the year, we have remained constructive on credit markets and mortgages, even as valuations have tightened. Our stance is based on the notion that credit fundamentals will stay reasonably healthy even as economic growth decelerates. Further, we believe that credit fundamentals will improve with rate cuts because stress in this cycle has mainly come from higher interest expenses weighing on corporations and households, unlike recent periods of stress in credit markets (2008/09, 2015/16 and 2020). This suggests that while credit markets have performed strongly, they could remain around these levels and spreads even tighten further.

The challenge with any landing is that we can’t be certain of the result until it is clear. Until then, we are merely hypothesising about the prospects, and every data point will be scrutinised for evidence of a hard or soft landing. This means that incoming data pose two-sided risks to the path for credit spreads.

With valuations stretched in some credit markets, we have been maintaining a long duration position, even though markets are fully priced for a return to more neutral policy rates across the developed world.

Back at home, the RBA has taken a balanced approach, with Governor Bullock pushing back against the idea that Fed easing and technical achievement of the inflation target in the monthly CPI are sufficient reasons to cut. The RBA’s language still showed some evolution, becoming less strident about time until cuts are feasible. The RBA didn’t ‘explicitly’ consider lifting rates in September but remain focussed on waiting for evidence that inflation is moving sustainably to the target band before pivoting. The RBA was wrong on the way up and the Bank may well be wrong on the way down. The leading indicators on inflation suggest trimmed-mean inflation will be back within the target band by mid-2025, quicker than the RBA expect. Downside risks are growing. Growth looks very weak - we have to go back to the 1990’s recession to see comparable growth rates and in per capita terms, growth looks even worse.

Markets remain supportive of strong returns from fixed income as global central banks take the first step away from restrictive policy towards a more neutral stance. There is likely a sequence of rate cuts still coming. There is no emergency now, but monetary policy should take some insurance against downside risks, in our opinion.

Positioning

Following strong performance from credit markets over the last 18 months, we are respecting valuations and have been taking some risk off the table. At the same time, we have progressively been increasing our interest rate exposure over the last quarter to position for the global easing cycle that is now taking place.

With US yields near lows and markets efficiently priced for cuts over the next year, we have taken profit on our long US rates positions. Deteriorating economic data in Europe has raised concerns that the ECB might need to step up its rate cut pace to prevent a harder landing. This outlook leaves us maintaining a long rates position in Europe to position for further downside to European yields. Markets like Australia and the UK have underperformed the move in US rates, and we have now rotated our interest rate risk into these markets where less easing is priced and where we expect outperformance vs US rates as growth and inflation slows in these economies.

We continue to see good value in inflation-linked bonds, especially in Australia where inflation remains higher and growth weaker. Market based inflationary expectations have moved substantially lower as inflation globally has moderated from very high levels and are now looking cheap.

Asset allocation will continue to be a key driver of returns where we are seeing a lot of dispersion in credit markets. This has allowed us to be actively rotating between sectors to take advantage of changing valuations as market volatility has increased. Markets like US investment grade and high yield are expensive once again and we have reduced exposure after having buying low in early August. We continue to favour Australian and European investment grade credit markets where valuations are more attractive. Australian mortgages continue to be our most favoured asset class from a valuation perspective where we have continued to add exposure as we move closer to the RBA easing cycle and mortgage arrears remain at very low levels. Australian subordinated debt has performed strongly and allowed us to reduced exposure in September in favour of European credit.

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