A New Regime: Markets vs Central Banks
- As the global recession risk rises, sustained inflation will likely leave pressure on central banks to keep interest rates elevated. This creates a positive environment for fixed-income investors.
- Investment strategist Greg Peters predicts the U.S. economy will easily outpace China and other nations in the coming years. Even as the U.S. national debt increases, it’s still an attractive environment for capital investments.
- A primarily domestic composition of U.S. Treasury bill holders inherently creates volatility, but the bond market as a whole is a stable landing place for investors.
What goes up must come down. At least, that’s been the prevailing market sentiment as central banks around the world have hiked interest rates over the past few years.
Yet even as a recession risk casts a long shadow on global economic forecasts, sustained inflation and a booming labor market — particularly in the United States — are decreasing the possibility that we’ll return to a low-rate environment anytime soon. At least, it won’t be anything like the near-zero rates of the early 2010s and the height of the COVID-19 pandemic.
For fixed-income expert Greg Peters, this is good news.
“I’m one of the few folks who don’t want a fixed-income rally,” Greg says. “I want yields to remain higher as I think that is really what investors and savers need.”
It’s not just a wish. As the Co-Chief Investment Officer at PGIM Fixed Income, Greg sees strong global macro indicators that favor a continuance of tight monetary policies in the years ahead. He predicts that central banks will likely have their hands tied with ongoing inflation, making it difficult to lower rates without causing dire economic consequences. That creates an easy buy-and-hold opportunity for Treasury bills and savings bonds.
Greg spoke with host Alan Dunne on a Global Macro edition of Top Traders Unplugged to explain the secular shifts that are favoring fixed-income investments. From assessing the sustainability of higher national debt in the U.S. to examining the near-term outlook for emerging economies, Greg unpacked the factors influencing the bond market and predicted how the Fed may react to an economic slowdown. Here are the key takeaways.
“Weakflation” and the U.S. recession risk
In December, most major bank forecasts agreed that while global growth will slow in 2024, the U.S. will likely avoid a recession. It’s good news considering many analysts in 2023 held a “not if, but when” mentality when it came to charting the recession risk, but Greg is quick to put the latest forecast into perspective.
“We have a 25% probability of a recession in the U.S. [in 2024], which is clearly lower than what was talked about last year,” Greg says. “But it’s still high, right? It’s still 3-X what the normal probability is,” referring to the historical long-term average of recession risk in the U.S.
Although some commentators have painted the alternative to a recession as being the Fed’s dream “soft landing” scenario, where its tight monetary policy drops inflation without any repercussions on the job market, Greg says a middle-ground scenario is more likely. Greg’s team at PGIM outlines a so-called weakflation as something in between a recession and a soft landing, creating an ideal spot for bond investors.
“Weakflation is essentially an environment where GDP is slightly below trend, maybe 1-1.5%, with inflation remaining above target,” he explains. In other words, growth is weak and potentially the labor market sees some negative effects — without entering a full-blown recession — but inflation stays elevated.
In this scenario, the Fed may find itself in a tricky spot. If inflation is still well above the Fed’s target of 2%, we’re unlikely to see significant rate decreases, even if there’s some contraction in the national economy. Maintaining the high interest rates favors fixed-income investors.
The Fed vs. everybody
It sounds simple enough — buy bonds when rates are high — but in many ways, this is an investor mindset shift from 2022 and early 2023 when the bond market had one of its worst years ever. There was an inverted yield curve where short-term interest rates were higher than long-term rates, and many observers thought rate cuts might come just as quickly as the rate hikes did.
Consider how in December 2023 the Dow Jones Industrial Average leapt to an all-time high on the news that rates would stay steady and might come down later in 2024. This is a common pattern of the past few years — stock market volatility hangs on every word of the Fed Chair.
Greg, however, advises that any hope of central banks reversing course at the same speed they raised rates is detached from reality. “There’s not been an acceptance of what central banks have been telling the markets,” he says. “It’s really difficult for central banks to cut rates when they’re above target on inflation.”
Put this scenario into perspective. The Federal Open Market Committee in December suggested it could consider at least three rate cuts in 2024, each by a quarter percentage point. That could amount to a drop from a federal funds rate of 5.25-5.5% to 4.5-4.75%. By comparison, the rate shot up by five full points in less than two years.
So here’s the disconnect. While the stock market reacts as if rates are suddenly going to fall to the pandemic-era floor, the far more likely scenario is that interest rates on fixed income will stay favorable for investors.
Yield is destiny
With bond yields at their highest level since before the Global Financial Crisis of 2008, portfolio allocation is in some respects simpler than it’s been for a long time. U.S. Treasury bonds held to maturity are essentially risk-free and are currently seeing a real rate of return above inflation. “The higher income that one receives from fixed income is back to what fixed income was intended to do,” Greg states. “Income is in the name.”
When it comes to Treasury yields, Alan asks, “What do you see as the normal range in this kind of new environment?”
Greg predicts yields to stay within 4-5% and a normalized yield curve as the Fed’s monetary policy stays relatively steady. “We’re in this higher-for-longer camp,” he adds.
PGIM celebrated the phrase “yield is destiny” in 2023, supporting the idea that bonds are regaining their place in a diversified portfolio. While stocks need a bull market to deliver a return, bonds work simply with high interest rates. “The bull market is actually the yield itself,” Greg says. Instead of needing the underlying asset to increase in value, as with stocks, the bond yield delivers a return regardless of market conditions.
Of course, the other side of government-issued bonds is the debt they’re fulfilling. “The U.S. now has the worst fiscal deficit that we’ve [ever] had without a recession or war,” Greg adds. “These are eye-popping numbers.” The question becomes, is it sustainable for the U.S. government to continue accruing so much debt?
Historically, foreign investors and governments held much of the U.S. debt. Now, especially as so many other nations have increased central interest rates, the foreign investment in U.S. bonds has drastically decreased. Greg terms this a “home bias” — when all else is equal, investors would rather buy domestic bonds.
“So as a consequence, we've seen a real shift in what we call the household share,” Greg says. “73% [of U.S. bond ownership] is coming from the household [and] 90% of that household is hedge funds.” This is notable for two reasons.
One is that U.S.-based hedge funds are more price-sensitive than foreign investors, and they’re more active in their trading. This creates more volatility in the bond market, meaning swings are more of an effect of who’s buying and selling than an underlying risk of government default.
Secondly, the home bias in U.S. bond ownership makes the market less sensitive to what’s happening around the world. Even if that weren’t true, the U.S. economy still holds an advantage in the international market.
Around the world
“We [at PGIM] are quite bullish on the U.S. on a medium to long-term basis. We think there's real potential for the U.S. to be a clear winner here,” Greg notes. Three viewpoints inform this position.
The Bank of Japan notably broke ranks with the rest of the world by not tightening its monetary policy to battle inflation. But if Japan were to reverse course and release its infamous yield curve control, it could influence Japanese investors to bring their funds back home — and out of U.S. and other international bond markets.
But Greg sees this as a minor concern. The increase in Japanese yields is likely to be slow, and because the Japanese yen was in freefall for most of 2023, the exchange rate has made it prohibitively costly for Japanese investors to go abroad. “[A higher Japanese yield in 2024] will have an impact on the margin,” Greg predicts, “but I don’t think it’ll be a wholesale change.”
As for China, Greg notes the nation is experiencing a decline in its working-age population. “They also don't have a social security net underneath, so that is a real tax on the economy for sure,” he adds.
Additionally, Greg sees deleveraging in the Chinese property sector and a slowing Chinese economy leading to decreases in commodity prices worldwide. The result is that China will have far fewer opportunities than we’ve been accustomed to in the past few decades, again making it less likely investors will leave the U.S.
Central banks in emerging markets have been some of the first to lower interest rates, and Greg sees investment opportunities particularly as China becomes less influential on a global scale. But he adds, “The difference of emerging markets today versus historically is that it’s less of a singular trade and more of idiosyncratic trade.”
In other words, emerging markets are not a singular bloc that all play by the same rules. Each country carries its own investment grade and a different level of financial risk. This means the U.S. can be a global leader in a race with many entrants rather than a false dichotomy of “domestic production versus outsourcing.”
The drivers of continued inflation
Speaking of domestic production, subsidy-ridden industrial policies are antithetical to the Fed’s attempts to lower inflation. More money pumping into on-shoring manufacturing and materials sourcing — including recent grants for microchip funding — can potentially prop up the economy while the central bank’s rate stays high.
Similarly, green energy initiatives are likely to keep inflation going. “You’re spending on near-term energy security and long-term solutions that decarbonize, so that is definitely inflationary,” Greg says.
Add a strong labor market, higher wages and new automation technology to increase productivity, and we see some of the factors that complicate the Fed’s “last mile” of lowering inflation below its target rate.
“It’s really difficult to see inflation come down meaningfully, when we’re at close to record unemployment rates and wages are still rising, albeit at lower levels,” Greg says. “We’re coming out of this long era of central banks not having to contend with inflation because it’s been persistently below that 2% target. Now, I believe it’ll be persistently above, and that changes the degrees of freedom the central bankers have to cut rates.”
Continued inflation means a continued restrictive monetary policy. For fixed-income investors, it seems yield is destiny indeed.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.
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