A progressive mindset – analysing the trends as rate cuts loom

Central banks, notably the US Federal Reserve (Fed), are expected to lower interest rates in the closing months of 2024, which will inevitably affect fixed income markets. At Fidelity International, we think that income-seeking bond investors will, therefore, need to reassess their allocations to the asset class and position their portfolios for a shifting policy landscape.

- Policymakers need to be forward-thinking and adjust borrowing costs 6–12 months in advance of any potential change in economic conditions.

- Only 50 basis points of Fed rate cuts are expected before the end of 2024 – a number that doesn’t fully reflect risks to growth.

- Employment data fails to capture input from small- and medium-sized companies thinning the size of their workforce.

- Consumer confidence among higher earners may have reached a level commensurate with a recession.

- Against this backdrop, it might be prudent for bond investors to be similarly forward-looking when seeking opportunities.

- The US corporate bond market has been surprisingly strong in 2024, and there is still value in US government bond yields.

- Long-duration positions in territories that have started cutting rates could be considered.

- Investors may also weigh-up global income strategies beyond the US dollar bond market.

- There are also opportunities in European markets to generate real returns while adding diversification to global income strategies.

- Currency-hedging remains essential, as shifting interest rates could impact currency valuations and, in turn, affect the attractiveness of fixed income strategies.

When trying to judge the direction of interest rates, it’s important for central banks to look ahead as well as back. Interest rate decisions work with a lag, meaning that policymakers need to adjust borrowing costs 6–12 months in advance of any potential change in economic conditions.

As such, assessing forward-looking indicators is vital when building a complete picture of the interest rate pathway. However, less than 50 basis points of Fed rate cuts are expected before the end of 2024 – a number that, judging by labour market and consumer data, fails to price in risks to growth.

As US inflation now appears to be under control, with encouraging consumer-related data for June 2024 underpinning rate-cut expectations, the Fed’s focus is shifting towards the labour market. Yet, non-farm payrolls survey data is proving an increasingly unreliable indicator of employment levels, mainly as response rates have fallen to a 30-year low. Instead, the government and education sectors are propping up the numbers.

In our view, this employment data fails to capture input from small- and medium-sized companies that are overwhelmingly thinning the size of their workforce. Should this trend start to translate, as it often does, to the wider US economy, we are likely to see an acceleration of the cutting cycle currently priced by markets as the Fed is forced to act faster than anticipated.

The aforementioned US consumer remains the key driver of short- to medium-term growth. At present, though, we feel there is still the risk that spending will slow. For some time now, consumers in the lower income brackets have been under pressure, with a sharp increase in homelessness and poverty rates. Furthermore, there has been a rise in the number of people supplementing their incomes with two jobs.

Accordingly, when trying to establish an accurate picture of US economic health, our focus is on middle- and upper-income earners who represent a significant element of the discretionary spending statistics. And our analysis reveals further signs of stress. This was indicated in a recent consumer confidence report that had reached a level commensurate with a recession despite headline US growth remaining positive.

Against this backdrop, it might be prudent for income-seeking bond investors to be similarly forward-looking when seeking opportunities. For instance, participants in the US could seek potential returns from duration while identifying income opportunities from more diversified portfolios. The US corporate bond market has been surprisingly strong in 2024, and there is still value in US government bond yields, particularly in medium and longer-dated issuance (5–7 years), based upon our assessment of the risks to the US economy over the next six months.

In addition, tactically long-duration positions in territories that have embarked on their rate-cutting cycles, such as the eurozone and Canada, could be adopted. As US market volatility is expected to rise as we approach the US presidential election, investors may also consider global income strategies beyond the US dollar bond market.

As mentioned, the European Central Bank has already started to reduce interest rates, and we have identified bond opportunities in Europe to generate real returns while adding diversification to global income strategies. By way of an illustration, European credit spreads have widened on the back of recent election-related volatility, and demand remains strong, with real yields at their highest levels in around 20 years.

Finally, currency-hedging strategies could be significant, as shifting interest rates may impact currency valuations, affecting the attractiveness of various fixed income strategies.

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