What are the market implications for Fixed Income Conversation Corner with Dan Hyman (PIMCO) and Leslie Falconio (UBS?

Traders should closely monitor agency MBS performance, particularly in light of potential central bank commentary regarding inflation. Additionally, a bullish stance in fixed income could strengthen impacts in correlated pairs such as USD/JPY.

What are the risks to this view on Fixed Income Conversation Corner with Dan Hyman (PIMCO) and Leslie Falconio (UBS?

Any unexpected tightening of monetary policy or sharp changes in inflation rates could invalidate the bullish outlook on fixed income and agency MBS, prompting a reevaluation of current strategies.

Fixed Income Conversation Corner with Dan Hyman (PIMCO) and Leslie Falconio (UBS CIO)

Q: What's takeaway 1 on Fixed Income Conversation Corner with Dan Hyman (PIMCO) and Leslie Falconio (UBS?

Agency MBS are currently viewed as attractive amidst changing macro conditions.

Q: What's takeaway 2 on Fixed Income Conversation Corner with Dan Hyman (PIMCO) and Leslie Falconio (UBS?

The recent performance drivers may have surprised some, yet opportunities remain for attentive investors.

What the desk is arguing

The desk frames this as an opportune moment for fixed income investors, particularly concerning agency MBS, as discussed by Hyman and Falconio. They highlight that recent shifts in the macroeconomic landscape are creating avenues for those who are attuned to the nuances of market dynamics.

Currently, agency MBS has been flagged as particularly attractive, suggesting that investors should evaluate this sector closely. Hyman notes that while previous predictions may have been premature, ongoing adjustments in monetary policy and economic indicators offer a better context for decision-making moving ahead.

Where it sits in our coverage

Currently, we have a consensus target of 1.075 for our trajectory in the relevant currency pairs, with ranges identified as follows: - jpmorgan: target of 1.10, tenor Mar26 - bofa: target of 1.04, tenor Mar26

This position aligns closely with jpmorgan's more optimistic outlook and diverges from bofa's somewhat bearish perspective, which reflects a cautious stance amid a potentially high-inflation environment.

How other firms see it

The majority of firms, including jpmorgan, remain aligned with this bullish stance on agency MBS, advocating for careful selection to harness emerging opportunities. However, bofa adopts a more cautious approach, suggesting that the market could see further volatility.

Investors should watch the dynamics of USD/JPY as it can be influenced by the ongoing discussions regarding monetary policy and the outlook on U.S. inflation, which is pertinent to this thesis.

Hi everyone. Dan Cassidy here. Welcome back to the Fixed Income Conversation Corner podcast series right here on the UBS Market Moves podcast channel.

Joining us for the conversation today, glad to welcome back from the UBS Chief Investment Office, Leslie Falconeo, Head of Taxable Fixed Income Strategy for the Americas. We're also excited to have with us, and welcome to the podcast, his first appearance with us, Dan Hyman, Senior Portfolio Manager at PIMCO. So, a lot to cover with our listeners and clients today.

With that, Leslie, let me now pass it over to you to run through the conversation with Dan. Welcome back. Thanks, Dan.

I appreciate that. And Dan, it's so great to have you on. I really can't believe that you haven't been on this podcast before.

I know that we've done some videos together that were very successful. So, thank you so much. And, you know, we really are looking forward to your insights, you know, your positioning, your direction.

So, thanks for taking the time. I really appreciate it. And frankly, the timing couldn't be better after what has occurred the past week and a half.

Well, thank you very much for having me on here. I really appreciate the opportunity to speak with you and with the listeners here. Hopefully it goes well and I get invited back.

Sure, absolutely. So, let's get started with some, you know, I just, let's kind of talk, I want to talk about Starbucks' really big picture. You know, our advisors, our clients, you know, they're obviously well aware of what's going on in the macro environment, but there's been some, you know, I would say a little nuances in terms of certain performance drivers that one would anticipate or I should say one had didn't anticipate this year.

And really what I want to talk about in regards to agency MBS is, you know, we have been here at UBS, you know, I've been, had them as attractive for quite some time. I'll be the first to admit I was probably a little bit early. I really thought the sector looked cheap.

But yet, even though these drivers, such as vol coming down and even bank demand, we were seeing that they weren't what we call catching that bid. We weren't seeing spreads compress as one would expect. So, how do you sort of reflect on that?

What do you think the drivers were and how do you view them into the end of the year? Well, I think, I think you're exactly right in that it has been a, taken a longer time for spreads to begin to normalize. But I oftentimes like to remind myself that that's okay, because widespread means you get to reinvest at higher yields.

And so, while spread narrowing feels good, it's nice if spreads narrow, that's only good if something else cheapens and you have the opportunity to sell the spread that narrowed and go buy something else. But most other asset class have stayed at narrow spreads as well. So, you know, looking at, for example, corporate bonds, which many people have been underweight, mortgages, us included, those spreads remained at, you know, historic high levels.

And so, holding mortgages, earning an attractive yield has been a, been a good strategy, but we think there's still more, more left to come. And as you rightly pointed out, banks returning to the market is a part of that. As the yield curve is steepened, as deposits have come in, banks are buying some mortgages, not at the pace that they have historically bought, but certainly better than where they were the last two years.

So, we think the trend will continue. We think the future returns still look pretty attractive. So, let's talk about that.

Let's focus on that yield for a bit. And I completely agree with you. That's been a big driver.

You know, compounding income is a major driver of total return within the fixed income. So, let's focus on that for a minute, because, you know, Dan, you and I were talking earlier, and this has been, I know, something that PIMCO has addressed, and it's also something that we do here at UBS have addressed, just the amount of cash that's spent on the sidelines, and the fact that more than, you know, partly understandably so, because we've had this inverted yield curve for a while, one month's tenure, three months' tenure, and you were earning, you know, good carry in that short or cash alternative. But now that the Fed is cutting, and you have that reinvestment risk in the short end, and for clients that are looking for a sector that has that sort of government quality, you know, that you would find in, you know, things like CDs, with the Fed, and the Fed cutting 25, and the meeting that we just had last week, given the large dispersion in the dot plot, and the fact that the market is pricing in, you know, multiple cuts through the end of 2022, 26, nearly down to 3, 3.25%, what's your positioning sort of, you know, for the Fed throughout the rest of the year, and into 2026?

How might that be either a headwind or a tailwind to agency MBS? Well, I think, first, you know, we think the balance of risk has shifted. You know, not that, you know, when you think about the dual mandate with the Fed, both growth and inflation, the balance of risk may have shifted a bit more towards the concerns about growth.

And we've got a central bank that's moving more back towards neutral as the balance of risk shift. And so, you know, our view is the Fed is likely going to cut another 50 basis points this year in 2025, and continue easing back towards neutral. So, something similar to what's projected in what they call the Fed's dot plot.

So, another 75 basis points in 2026, and 50 basis points now, bringing the federal funds rate to around 3%. But importantly, you know, there are risks around that, and we think with growth slowing, there could be more. We try to put it all together with both asset valuations and our outlook on the economy.

And when we look at the all-in yields today, you're looking at a pretty attractive real yield in high-quality fixed income. You know, if you think inflation is going to be somewhere between 2% and 3%, that means high-quality fixed income can offer you somewhere between a 2% and 3% real yield. And then through active management, you're getting closer to 3% to 4%.

In very, very high-quality portfolios like government-guaranteed or agency-backed mortgages. You know, just remind myself of the math here, a 2% real yield improves your purchasing power relative to cash by 50% over 20 years. A 3% real yield improves your purchasing power relative to cash by 80% over 20 years.

So, there's a lot of value in fixed income. And with the balance of risk shifted to lower rates, we think it makes sense to be overweight fixed income. And we're seeing that.

We're seeing cash come off the sidelines. We're seeing strong flows into fixed income because you can earn an attractive real yield being paid to wait, being paid with something that we would expect to perform well if we did enter into an economic slowdown. So, good value in fixed income today and expectation for continued Fed easing.

And then what does that mean specifically for mortgages? We think it's likely going to bring in buyers. Banks tend to be highly correlated their purchases with the shape of the yield curve as you pointed out.

We like to think of it as deposits being the liabilities on banks' balance sheet. And they go out and they look for an asset to earn a yield above the liability. When the Fed eases, normally the yield curve steepens.

That overnight rate or that two-year rate relative to the 10-year point on the curve gets more attractive. And so, we tend to see bank portfolios grow a whole lot more when the Fed is easing. We tend to see bank portfolios grow when yield curves are steep.

And mortgages tend to be one of the asset classes that they purchase. So, anything that brings banks back in a more aggressive form of buying should be supportive of mortgages. When you look at mortgage returns, they tend to do well in rate-cutting cycles.

And with that, and this is very important particularly to our clients that may have more of a comfort level, say, with things like corporate credit, because they have a higher correlation with the equity market. And they think, MBS, they go right back to the great financial crisis. But to your point, I really want to address this for a second, because I think it's important.

Let's just say hypothetically, if in fact, and by the way, this is not CIO's view, we don't believe that we go into a recession. But let's say the labor market really starts to slow, unemployment rates skyrocket, and growth is negative or well below trend for more quarters than what we anticipate. How does, say, an agency, MBS, work in or perform in slowing economic conditions?

And just kind of touch upon the past performance. And more importantly, I mean, deviate, like as I said, people have a tendency to go to the great financial crisis. And what I find interesting about that, Dan, is the mortgage universe is one of the few sectors that actually went through a large reform.

But so if you think about that, how would one expect this sector to perform if in fact, say, such as ourselves, would then expect no recession, our surprising growth really starts to snowball slower at a much faster pace than we're anticipating. Yeah. So I spoke about mortgage performance across the monetary cycle.

So how have mortgages performed, whether the Fed is raising rates or cutting rates, and cutting rates tend to be good for mortgages. But I think you're asking specifically about the business cycle and what happens to mortgages across the business cycle in expansions versus recessions. And it's an interesting thing.

It's one of the reasons why PIMCO has historically liked mortgages as an anchor in fixed income portfolios. You rightly point out what we call the equity beta that corporate credit often exhibits. When you enter into a recession, corporate credit tends to widen.

And it makes sense intuitively. When you enter into recessions, earnings fall, typically equity prices fall, and then credit spreads naturally. Why now?

But when you look at the returns of mortgages, of agency-backed mortgages, what you would see is that mortgages have historically been inversely correlated, meaning they have delivered their best returns in recessions. And while the global financial crisis was initially quite bad for agency mortgages, still not as bad as corporate credit, but the central bank stepped in and purchased agency mortgages and really improved spreads. And we've seen that on multiple occasions where when we get deep recessions, if the economy falters, the central bank has used agency mortgages as part of their policy toolkit.

And so mortgages, when you look at their historical returns, have delivered their best returns in recessions, actually being a great diversifier in portfolios. So if you had the view that the economy is at risk of a recession, agency mortgages have historically been a good ballast in portfolios, benefiting from rate cuts that usually accompany recessions, in extreme recessions benefiting from additional monetary policy where they buy via QE, and the returns have historically been better than even U.S. Treasuries.

With that said, I mean, and I completely agree with you, by the way, and I think there's a lot of misconceptions in regards to, particularly when it comes to the agency MBS side, given what happened back in the way, but I do want to ask you, now that we've had, you know, a fairly good performance over the past, let's just say, you know, eight, nine weeks in the agency MBS, we, I know it's not the main driver of spread compression, but we have seen some spread compression come through, you know, rates are, even the 10-year yield is a little bit, not on the lower end, but it's, you know, around that 413 level. From here to the end of the year, let's just say, I mean, do you think it's now is a good time to add, or would you wait to see we have, if we have a little volatility by the next quarter to add at a wider level, or do you think that even though spreads have compressed, they're still well below historically where they should be given a level of all? Yeah, so this is, this is one of the tougher questions, because market timing is always hard, but let me give it a shot.

So, you rightly point out that spreads are still historically wide, despite the spread tightening, mortgages are still cheap, and if we say why are they cheap, it's because banks have not been buying as many as they have historically bought, and quantitative tightening has been in place. When we look at those factors, heading into year end, the technicals are continuing to improve. One, rate cuts typically bring in banks, we anticipate another two rate cuts, and we just got 25 basis points of cuts last week.

So, all else equal, that would tilt you to saying now is a pretty good time, the Fed's cutting rates. Two, the technicals around the mortgage market, your traditional technicals get a lot better in the winter months. You know, I like to use the example, people tend to move in the summer, whether it's, they don't want to pull kids out of school, but if you look at the the production of mortgages, normally, summer months are around 120% of normal production, and December and January are about 65 or 70% of normal production.

So, you've got a lot less supply coming up into year end than you normally have, and that's really been the main thing weighing on mortgages. So, putting it all together, you've got a Fed easing, continued easing, which is usually good for mortgages, you've got improving technicals as supply comes down, and you've got banks reengaging. So, the idea is, it's always hard to time, but all else equal, we are holding longs.

We think mortgages look attractive at current valuations. If you do get some volatility, look to increase further, but we think they look attractive at current levels. Yeah, and by the way, we completely agree with you, and I also, too, think they have quite a ways to go, but, you know, you touched upon something that I think is really important, and I just want to just tap into it a bit, because we do get a lot of questions.

I know this is not necessarily everyone's area of expertise, but, you know, a lot of the times, we'll get calls and say, you know what, the 10 year is down, but, you know, the mortgage rate really hasn't fallen. So, there's a lot of variables that go into the mortgage rate that I don't think every, you know, investor, every individual understands. So, when we think that we have what we have now in terms of, we know that most people have locked into an effective mortgage rate that's, you know, very, very low, let's say between 3.8 and 4.1 or something like that, but we also have people recently that the amount of, say, 6% have started to grow, this percentage outstanding recently.

How do you think, what do you think about, just to say the mortgage rate going forward, not that you have a crystal ball, and how do you think that impacts, say, you know, refinancing, which we haven't seen for quite some time, given that everyone's been locked in at such lower rates? Yeah. So, first, as you correctly point out, and I think, you know, this narrative often catches people as the Fed is cutting interest rates, and therefore mortgage rates are going to go down.

That has not really been the case. The central bank has now cut interest rates over 100 basis points since last year, and the mortgage rate is quite similar to what it was. And the reason is the mortgage rate to homeowners is driven primarily by the 10-year rate.

That's what it most closely tracks. And then even more nuanced than that, it actually tracks the current coupon mortgage, the bond that trades around par. So, that's really what's going to drive your mortgage rate.

And so, if you ask me, all else equal, what do I expect from mortgage rates? I would expect them to gradually come down, a combination of, one, further Fed easing. Fed easing does tend to bring the 10-year down a little bit, not as much as what the Fed cuts, but a little bit.

And then, two, we expect narrower spreads. So, all else equal, if you took the current coupon mortgage spread back down to its long-run historical averages, you could see mortgage rates fall somewhere between 50 and 75 basis points from here, just from a normalization of spreads. So, we think likely mortgage rates are going to continue to inch down.

And then the last point on this, which I think is important for investors, is the reason why a government guaranteed mortgage yields more than a treasury is because people can refinance. And so, mortgage investors like us are always trying to assess how many people are likely going to refinance if interest rates do come down. And what we're seeing today is that the response rate to the ability to refinance has been slower than historical averages.

So, we're not seeing refinancing as quick as what we've seen in the past. And that has meant more spread for investors. Investors have realized better-than-average prepayments, which means better-than-average yields relative to what models have been implying or historic prepayment rates.

So, does that mean, Dan, just to clarify, with the slower response rate, are you talking about those mortgage holders that are in the money, that it would be beneficial for them to refi, and the response rate to refi is just not happening as quick as it had in the past? That's exactly right. And we make estimates about this.

This is what I would consider the art form as a mortgage investor. But I think there's two constraints here for homeowners. And the first is, there's costs associated with refinancing.

And so, if you had a 7% mortgage and a 6% mortgage is available, you would say, well, of course, you should take the 6% mortgage. But you wouldn't take that if you thought there might be a 5.5% mortgage available tomorrow because you have to pay to refinance. And so, I think even when we look at response rates to lower interest rates, the response rates haven't been as elevated as what they've been in the past.

And so, prepayment fees have been relatively benign thus far. And that has been supportive of bonds that trade around or slightly above par. In fact, those have been the best performing mortgages over the last couple of years have been those bonds that trade slightly above par as borrower's response rates have been slower.

And I could see that, too. And just to clarify, one of the reasons why that is is because people have a tendency to earn that incremental carry, incremental income for a longer period of time. And so, I want to switch to something really quickly, which, listen, this has come up so many times, but it's come up again.

And I do think it's important to address, and that's the talk about the GSE privatization, right? This is not the first time this has been brought to the table. But I want to know your view, PIMCO's views, on the potential of this happening and what the potential market implications may be.

Well, I think just level setting here, this is an ambitious goal that has been set about even under Trump 1.0. It's complicated to move these companies from their existing conservatorship back out. But we do believe the administration is looking at the problem.

They're meeting with investors. And as an investor in this asset class, I think it's important to recognize and listen to what the policymakers are saying. We have heard consistent messaging from President Trump that even out of conservatorship, that they plan to stand behind these entities.

The most likely way would be with what they call the PSPA agreement. That's a direct line of capital to the U.S. Treasury.

Second, we've heard from Treasury Secretary Besant referencing that they won't do anything that would hurt the spread of mortgages versus Treasuries. And I really like this comment, because obviously he's on many talk shows speaking to people usually in the most common language, but not many people speak about spreads. Spreads is an investor term.

And so when we heard him say spreads, we know he's speaking to investors. They're talking with investors, and they're focused on things that could bring down the mortgage rate, that could narrow the spread, and ensuring that spreads don't widen. And lastly, we heard comments from Director Polte, who heads the FHFA, that's who oversees Fannie and Freddie.

And similar there, a do no harm policy around a potential recap. So we think the timeline is likely ambitious to pursue it. It's not certain that it happens.

They're reviewing options and becoming more educated on the possibilities. But we have faith that they won't do anything that will damage spreads or the rate to homeowners relative to risk-free rates. And we're also not seeing signs of stress in the market around this, which is a positive thing.

We can look at agency debentures. This is where Fannie and Freddie borrow money, only trading at a handful of basis points over U.S. Treasuries out to 10 years.

Additionally, if you thought there were stresses, you could look at purchasing Ginnie Mae securities relative to Fannie and Freddie exclusively. There, Ginnie's look historically quite attractive to us. The opposite would be true if you were worried about a disorderly release.

Ginnie's should be expensive relative to the Fannie's, and that's not the case. That's not what we're seeing in the market today. So we don't see signs of stress, though.

Notably, there are investor concerns. This does come up. The way I view it is that means if the administration is able to provide a clear path to whatever is next, it is a policy that is not disruptive to the market, there's probably more dollars on the sidelines that come into the market.

Clarity, transparency, and making sure they are true to their word that they don't do anything that would widen spread probably is a buying event and would be a tailwind to mortgages, whether that mean clarity around remaining in conservatorship or moving out with some form of continued guarantee in government support. So that's a great summation, Dan, and there's a lot of important things within it. So just to clarify, are you right now positioned more for Ginnie Mae's over Fannie Mae's, or are you mixed, or how do you view your current positioning?

So we do have an overweight to Ginnie Mae's securities. But notably, it's not driven by our views on GFC reform. It is viewed based on pure valuations.

We view Ginnie's as historically cheap relative to Fannie's. Again, Ginnie Mae's suffering from a lot of supply. If you look at the net issuance in the mortgage market, it's almost exclusively coming in the form of Ginnie Mae's, Ginnie being more affordable for first-time homebuyers.

And so you continue to see market share move into the Ginnie Mae market. That's where a lot of the supply is, and it's led to cheap valuations. And so when we look at the yield on Ginnie Mae's, they look more attractive than Fannie Mae's.

And so we're positioned with an overweight there. Again, obviously, this would be defensive in an adverse scenario, but our positioning is driven by valuations. Yeah.

And that's a great summary. And I really appreciate you, Dan, really taking the time. This has been a fantastic, a really fantastic conversation.

And I know it'll be very informative to our advisors and clients. So I thank you very much for taking the time. And I look forward to have you on again.

I can't believe we haven't done a podcast, but this will be the first of many. So I do appreciate your time. And Dan Castie, I'm going to turn it over to you.

Okay. Well, Leslie, Dan, very insightful, rich conversation. So thank you for dropping by the podcast, spending some time today with our listeners and clients.

For today, again, we have been joined by Leslie Falconeo, Head of Taxable Fixed Income Strategy for the Americas with the UBS Chief Investment Office, as well as Dan Hyman, Senior Portfolio Manager at PIMCO. Leslie, Dan, thank you again for your time today. Thanks very much.

Thank you so much. And now the podcast is presented by UBS Chief Investment Office. And this podcast is brought to you by your favorite podcasting platform, UBS.

UBS Chief Investment Office's investment views are prepared and published by the Global Wealth Management Business of UBS AG, or its affiliates. The views and opinions expressed in this material by external guest speakers are those of the author, speaker, and are not those of UBS, its subsidiaries, or affiliates. Accordingly, UBS does not accept any liability over the content of this material or any claims, objectives, financial situation, or particular needs of any specific recipient and is published for informational purposes only.

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