Fixed Income Conversation Corner with Dan Hyman (PIMCO) and Leslie Falconio (UBS CIO)
The desk believes that the current fixed income landscape presents unique opportunities amid volatility caused by geopolitical tensions, particularly in the Middle East. As discussed in the recent PIMCO and UBS podcast, market participants are seeing widening spreads and increased uncertainty, suggesting that astute investors might find value in agency mortgage-backed securities (MBS). With a consensus target for the USD/EUR at 1.075, traders should navigate carefully given the lack of high-impact events on the calendar that might shift sentiment temporarily.
What the desk is arguing
The desk posits that recent geopolitical events, particularly unrest in the Middle East, are catalyzing volatility in fixed income markets. Per the full note, there's been significant spread widening, indicating potential opportunities for investment, especially in agency MBS, where relative value might be captured during these turbulent times.
The commentary from PIMCO's Dan Hyman emphasizes the need for vigilance, suggesting that the current climate might lead to diverse market reactions and adjustments in risk premiums, which could open up advantageous entry points for fixed income investors.
Where it sits in our coverage
The consensus target for the USD/EUR currently stands at 1.075, with a range suggesting volatility between 1.04 and 1.12. Firms with pertinent targets include: - jpmorgan: 1.10 (Mar-26) - bofa: 1.04 (Mar-26)
This bullish perspective aligns with jpmorgan at the higher end of our coverage spectrum, indicating a growth outlook amid the unfolding economic landscape.
How other firms see it
Analysts aligned with the desk's view include jpmorgan, emphasizing approaches to navigate current market conditions. In contrast, bofa presents a more cautious stance with their lower target, reflecting a more conservative outlook for the currency pair given the recent market volatility.
Market participants should keep an eye on agency MBS spread movements as they reflect broader sentiment shifts shaped by geopolitical uncertainties and their impact on monetary policy decisions.
What the calendar says
With no significant events scheduled in the immediate future, traders will need to remain agile and responsive to market fluctuations driven by evolving geopolitical contexts, keeping in mind that unexpected news can rapidly affect fixed income allocations.
01Geopolitical tensions, particularly in the Middle East, are increasing market volatility.
02Opportunities may lie in agency MBS as spreads are widening.
03The consensus USD/EUR target is 1.075, with a range from 1.04 to 1.12.
04No significant economic events are on the immediate horizon, leaving room for speculative volatility.
Market implications
Traders should monitor the USD/EUR pair closely, particularly if spreads in agency MBS start shifting in reaction to further geopolitical developments. Any news from the Middle East could prompt quick adjustments in valuations.
Risks to this view
A stabilization of geopolitical tensions could lead to spread compression in fixed income markets, which may invalidate the current bullish stance on agency MBS profits and lead to increased caution among traders.
ubs
Hi, everyone. Dan Cassidy here. Welcome back to the Fixed Income Conversation Corner podcast series here on the UBS Market Moves podcast channel.
Joining us for today's conversation, glad to welcome back from our partners at PIMCO, Dan Hyman, Senior Portfolio Manager. Dan leads the Agency Mortgage Portfolio Management Team at PIMCO and we're, of course, as always joined by Leslie Falconeo, Head of Taxable Fixed Income Strategy for the Americas from the UBS Chief Investment Office. So with that, Dan, Leslie, thank you once again for dropping by here on the series.
Leslie, let me now turn it over to you. Thank you, Dan. Dan, thanks again for doing this podcast.
I mean, you and I have had conversations, you know, in the past. We're always fortunate enough that we happen to catch them when there's these little pockets of vulnerability, I'd like to call them. But we really are interested in having your thoughts, you know, overall in terms of what you think about the markets going forward.
And I obviously want to, as we end the first quarter, you know, tomorrow, I just, there's been a lot that's happened this quarter, but I just want to really touch upon the recent events, as we end the quarter, and how you're looking at, say, the Middle East, how this, you know, current conflict could impact the financial markets. How do you think this could impact returns going forward for things like agency MBS? So really, really interested in your thoughts.
And thanks so much for being on. Well, thank you. Thank you so much for the opportunity to join you today.
Obviously, markets have been quite volatile. It's a fluid situation in the Middle East, so excited to be on here and have an opportunity to discuss it and think out loud with you. Great.
Thanks so much. So I do want to, let's testify now. Let's think about the events that are currently happening and the disruption.
As you mentioned, there's a lot of uncertainty. You know, we've had spread widening across the board, right? And most fixed incomes and just quote unquote, fixed income risk assets that are spread product.
So how are you thinking about how this current conflict might impact agency MBS going forward? Yeah. So I think when we look at, you know, any kind of market moves and in a volatile period like this, I think one, we have to have some humility about how long it's likely to persist and our degree of confidence in what the resolution will be.
Will it escalate further or will we see some form of deal and return to normalcy? So I think with some humility, what we try to look for in markets is we try to look for overshoots or we try to look for things that, you know, may be a function of, of underperforming due to volatility, but shouldn't have structurally changed. And what I mean by that, you know, for example, let's take something like a corporate credit.
This is a shock to the system. We've seen a decline in equity prices. We think this will lead to lower than what growth expectations were previously.
And so it's natural to see a widening of spreads, but you have to debate how much widening should have occurred. Is it enough? And I think when we look at credit spreads, we still see credit spreads trading at historically narrow levels.
Corporate spreads are only a handful of basis points wider on the month, despite the increased uncertainty. And to us, that doesn't look like an overshoot. Contrast that with the agency mortgage market, where spreads have widened, but we've actually moved to higher rates.
So some of the risks associated with mortgages are actually lower today. The prepayment risk goes down as interest rates have moved higher. The yield has gone up substantially as the prepayment risk declined.
Your yield has actually gone up more than one for one with treasuries. And your supply will go down at these current levels of rates. So to us, agency mortgages looks like an overshoot.
It looks like an opportunity where we would want to add risk, where we've seen a widening of spreads and a decrease in the risk. We have less convexity risk from here. So that looks like a classic overshoot to us and an opportunity to add.
And we just remind the listeners here, we still have the tailwind of Fannie and Freddie buying 200 billion bonds, something that should be very supportive for the market at these levels of rates, limited supply, strong buy program from the GSEs. We think the asset class is well supported beyond the initial shock here. You know, and I absolutely agree, and I do.
We've been, have agency MBS as the most attractive. And I completely agree that the spread widening that we've seen in the agency MBS side is a bit overdone. And to your point, I mean, IG corporates are maybe month to date or year to date, maybe anywhere from, I think they're eight or about six basis points wider, year to date like 12 basis points wider, you know, excuse me, six a month, say 12 year to date, very, very small widening in IG corporates.
But when we look at that overshoot, and I agree, why do you think that's happened? Like what is, was it too much optimism in terms of, like I said, the GSE buying? Did it get a little bit, a little bit over exuberant in terms of when an announcement was made?
Why do you think this overshoot has occurred? Is it strictly volatility? What's been behind it?
Yeah. So, you know, I think, you know, we try to make estimates, we try to put together analogs from what's occurred to try to estimate what is driving it. And I think just as a starting point, you know, I generally have a view that mortgages is a negatively convex product.
So anytime interest rates move more than a standard deviation in a month, you should expect some degree of underperformance. So with a 10 year up, you know, a little over 40 basis points in this move, that's greater than a one standard deviation move, and therefore you should expect some underperformance. The second is, is were there other flows that have taken place that may have led to further overshoots beyond the traditional convexity costs?
And there too, we think there are. One, the traditional negative convexity associated with mortgage servicing. So when rates move a lot, servicers naturally have some mortgages they need to sell.
And so we've seen some selling from the servicing community. Second, we've seen some deleveraging from what we believe is the mortgage REIT sector. These are entities that are typically run between 8 and 12 times levered.
So their convexity is, you know, magnified. So when you have these moves, they usually need to take down some risk. We've heard anecdotally of some selling from those entities.
And then lastly, you know, what you'll often hear referred to as pot shops. These are the shops within some of the hedge funds who tend to have very tight stops on risk. And so as you start to see a widening, as you start to see moving rates, you've seen some deleveraging from that community.
And I think you've seen it there in swap spreads as well. But the fixed income flows have continued to remain positive. Active managers have been gradually adding some mortgages here and able to absorb some.
But I think, you know, with the benefit of real money, you have time to gradually add and get the lay of the land better. When you're running levered portfolios, you have to act now. And so the deleveraging comes quite quick, whereas the recovery or the adding from the real money tends to come at a more gradual pace.
So I think that's what happens. Quick pace of rates, greater than one standard deviation move or some deleveraging in very short order. And then active management gradually adds risk.
And, you know, we hope for a recovery in the coming quarters. Yeah, I mean, that's something I always explain to our investors who do the agency and the F5. You know, that's just the short volatility.
But really, with most products, when you have that delta, that change in yield of 50 basis points, say, or around that, you know, we did at the end of February. Remember, we were about a 395. The mark was pricing in, you know, about 60 basis points of cuts.
We had all this AI disruption really, really leading the headline. And everyone was, oh, my gosh, slower growth. You know, within a couple of weeks, it shifted to the inflation front.
Yields rose very quickly. And as we know, it's much different to if yields rise, you know, 40, 50 basis points over a three month time period versus a three week time period. So when we think about that move and how much we've moved today, when you look at the 10 year going forward, what's sort of PIMCO's outlook on, you know, 10 year treasury yields?
I have to mention the 2022 scenario just because people, you know, our investors, unfortunately, you know, popular media likes to link that during a time when yields are rising and equity was going down because it was inflation driven. What do you think about that scenario? And more importantly, you know, how is your outlook, how the Fed might react in 2026 versus what's priced in right now?
Yeah, a lot to unpack there, but I think really it's that's the analysis that a lot of us are going through. So first, let me start with the risk of 2022. And I think it's important to remind investors that starting yields are in a much different position today than where we were in 2022.
As a mortgage person, I like to use, you know, the proverbial Fannie 2 as the example. There, we had a dramatic sell off in 2022. In order to recover your losses from that, it would have taken 11 years of earning coupons to offset the drawdown.
If that same event were to happen today, you're talking about three and a half years to recover. So one, the order of magnitude, you're just starting with a lot more yield, even at the index level. Today, indexes, you need over 100 basis points rise in rates before you have a negative return.
So those negative, you know, 12, 15 percent returns we saw on some of these benchmarks are really would take something much more extreme than 2022. So we've got a lot more downside protection within fixed income because the starting yields are so much better. The second thing I think you touched on, which is which is, you know, interesting to us and I would categorize as likely an overshoot is interest rates, the backup in rates.
What we've seen occur is markets had priced in cuts this year, expecting lower growth in a more accommodative Fed. And as recently as last Friday, the market began pricing in hikes. The market began to price in this inflation from the spike in oil.
But it's, you know, oftentimes you can see the first order impacts of the inflationary shock transform into quickly into a growth shock. You know, I go back to post-global financial crisis feels like a world away. And let's hope the next one is a world away.
But oil stayed above one hundred dollars for almost four years in real terms. You know, that would put it up towards, you know, closer to 200 today. And yet the inflation numbers stayed below the Fed's target.
Growth remained positive without a recession. So but it was relatively low. So I think, you know, this shock may not be as inflationary beyond the headline that we see from oil and may end up more impacting growth, which could bring us back to a rate cutting scenario.
So this looks like an overshoot to us. And this is an opportunity to add interest rate risk in portfolios. And we've been doing that incrementally again, recognizing it's a fluid situation.
There's a fair amount of uncertainty. But realizing price hikes in the U.S. seems less likely. Yeah, I totally agree.
I mean, you know, we have and, you know, what's interesting, Dan, too, and we and we talked about this with our team as well, when we look at the how much the market, the fixed income markets are forward-looking. There's always convergence and divergence between what the market is expecting and what the Fed guides, right? The Fed's looking at backward-looking data.
But I mean, I think that the quick change from the 60 basis points of cuts they had priced at the end of Feb to the potential hike, you know, we viewed, we deemed much too extreme. And, you know, we understand that we're still sort of, you know, coming off that, you know, goods inflation is still there from tariffs. Yes, you might have a couple months of, you know, higher, higher inflation numbers, given what's happened with oil and gas.
But we don't look at this as a long-term impact. And we ourselves are as well, incrementally adding interest rate risk. Now, when we think about sort of agency MBS, I do want to, I want to talk to you about two things.
One is that, you know, the 30-year mortgage rate went from like, what is it, 599 at the end of February, all the way up to like a 635. And we know that the administration is much, is honed in as they are on affordability. We know that is part of the, that's not really helping them right now.
But when we look at these Basel III and all this regulation changes, and we know that bank buying is such a big part of mortgage performance, how do you see that going forward? How do you see bank demand? How do you see how some of these changes could be a tailwind to agency MBS performance?
I think, I think that's right. And what you point out is it has not been a tailwind. You know, coming out of 2022, we saw the opposite of what we typically see.
We saw deposits leading the banking system. And so, deposits being the liability, banks go out and buy an asset, and they earn the spread in the middle. That's their net interest margin.
And banks went from typically buying about 100 billion mortgages a year to net selling. We had the Silicon Valley bank liquidation, as well as banks just taking a step back, being underwater, not seeing deposit growth. Now, the market shifted, and we're seeing deposit growth once again, at a pretty elevated pace.
We saw about a trillion and a half with deposit growth last year. Deposits now back at all-time highs. And to your point, we're seeing some Basel III endgame reform.
Now, those have not gone through, but we think importantly, the outline has been put forward, and it's implemented as is. That will give banks substantial room to add additional assets. It frees up capital within the banking system.
Now, banks may not use all of it. Banks are currently not up to capacity, but it does give them a fair amount of flexibility. And we know agency mortgages or residential mortgage loans, holding either on their balance sheet, has been a preferred place for banks to deploy.
Nice, attractive spread over funding. And so, we think banks come back to buying, and that's been a large missing piece. And one of the key reasons why we think agency mortgages have been so cheap has been that missing buyer.
And so, with reform as a result of Basel, with continued deposit growth, bank demand is likely to be positive and likely to be a tailwind for the sector after having been a headwind for so long. So, do you think, when you think about some of the risks in agency and BS, and again, you and I are in complete agreement of the value opportunity there and the continued opportunity there, what are some of the pockets of mobility that you're concerned about? Is it, besides going to 5% tender, treasury yields, what is it that could cause you a point of concern with agency and BS from now to the end of the year?
Yeah, well, I think, generally speaking, if you said, what are the potential headwinds for the asset class, I would say, over the near term, the probably most front and center one would be if fixed income flows were to change and go the other way. Fixed income flows have been exceptionally positive, and that's been supportive of the asset class. But when you think about your list of buyers, you've got banks, which have been generally slower than average.
We think they're going to come back in a more meaningful way, but in current day, they haven't been that meaningful. You still have a Fed engaged in quantitative tightening. Between those two entities, they make up about 50% of the buyer base, and really, it's been the asset manager community doing the heavy lifting.
So, if you had something that turned the asset manager community from buyers to sellers, like outflows, we think that could be something that could widen spreads over the near term. We're not seeing that. In fact, fixed income flows have continued to be quite strong.
We get the data with a lag, but anecdotally, we see them being still quite strong. Again, to your point, yields are attractive here. But if it didn't, that would be a headwind to the sector over the near term.
We try to look at the data and recognize that that could be a headwind if it were to change. In terms of your current, say, overall position within fixed income, obviously, agency and VFs, what other sectors are you taking a look at that might be of interest to our investors, particularly given some of the widening we've seen in volatility? I'll tell you, from our standpoint, Dan, we remain in the higher quality.
We still like the higher quality sectors within fixed income. We know that you're obviously learning a great amount of carrying compounding income within those greater credit embedded sectors. We're not leaning that way in our position because we do think the Fed cuts twice.
We do think interest rates go down by the end of the year. We do believe that growth, while above trend in the second half of the year, will show a little bit of softening. So that's really our view.
But how are you looking at in terms of opportunities within fixed income outside of even just agency and VFs? Yeah. So I think, generally speaking, we're like-minded with a bias up in quality.
Now, our base case is currently not for recession. And so if you have positive growth, you generally do see reasonably low defaults, relatively good performance in credit. So when we take our credit risk, we're trying to find assets that are still fairly priced.
And so one of the areas that we'd like is securitized credit. Just simply one simple way to think about it, the non-government guaranteed mortgages, sometimes referred to as like RMBS 2.0, they're never going to trade at a narrower spread than your government guaranteed mortgage. So the fact that the government guaranteed space, your Fannies, your Freddies, your Ginnies, are historically cheap, your non-government guaranteed sectors have some residual cheapness there as well.
So securitized credit stands out to us as still an opportunity. When you look at PIMCO portfolios more broadly, that's where our overweights are on the credit side. It's focused on the securitized credit.
Whereas if you look on the corporate credit side of things, you've got historically narrow spreads, not only for a good environment, they're historically narrow in a non-recessionary environment. So if you look at something like corporate credit, long-run averages are still about 25 to 30 wider than they are here for non-recessions, and then obviously much, much wider recessions. When you look at securitized credit, you're looking much closer to long-run fair value on spreads.
So those look like more opportune places to take our credit risk. Second, the underlying assets. When you think about U.S. housing, a focus on the policy side.
There too, we think U.S. housing remains on pretty firm footing. Directionally, it's likely to go up, not down. And so there again, you've got an asset that de-levers due to the amortization.
You've got an underlying asset that's appreciating over time. And so we think securitized credit, U.S. residential real estate looks like an attractive place to take our credit exposure. On the CLO side, tax allocations, they're again focused on the top of the capital structure.
When we look there, we've seen more widening in that space than we've seen in credit. Obviously, the floating rate nature, you're seeing yields come down a bit, but still decent spreads. And then the last thing, more niche sectors within the government guaranteed mortgage.
People are a little bit concerned with prepayment risk, look at the floating rate sector in the agency mortgage market. They're offering spreads commensurate or higher with the CLO market and getting that agency backing on top of it. So there's even other areas within the agency mortgage market that look like other risks that we think are still attractive we can tailor.
Again, those assets specifically customize cash flows for active management, non-traditional bond benchmarks, but a good opportunity for active management. That's great. And that was a really great summary.
And I thank you so much for taking the time to speak with us. We're very much aligned with our thinking, both on the agency and securitized side. We do believe there will be a point in time within the corporate credit side to take an opportunistic relative value point of view, but we just don't think we're quite there yet.
So we are along the agency and securitized side. So thanks so much for your time. I really appreciate it.
And I look forward to having you on soon. Thank you. Thanks, Leslie.
It's a pleasure to be here. I really appreciate the opportunity to speak to UBS. Thank you for tuning in.
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