Fixed Income Conversation Corner with Gene Tannuzzo (Columbia Threadneedle) & Leslie Falconio (UBS CIO)
The desk indicates that fixed income markets are poised for evolving dynamics as we approach 2025, foregrounding both vulnerabilities and opportunities influenced by shifting monetary policies. Per the full note from UBS, insights shared by Gene Tannuzzo of Columbia Threadneedle underscore potential shifts in yield perceptions amid monetary policy adjustments. Importantly, both discussions highlight the need for adaptive strategies as the landscape suggests a balancing act between risk and reward, underpinned by macroeconomic developments and central bank directives.
What the desk is arguing
The desk argues that as we enter 2025, the fixed income market will display significant opportunities influenced by the changing trajectory of monetary policy. This perspective is informed by a detailed conversation between market experts, Gene Tannuzzo and Leslie Falconio, who identify critical yield movements that suggest tactical positioning is essential.
Supporting this assertion, the dialogue emphasizes the importance of monitoring shifts in central bank policies, notably in light of inflationary pressures which may dictate future yield movements. Specifics are scarce in the commentary itself, but the recurring theme of vulnerability suggests a more pronounced degree of caution needed in portfolio allocations.
Where it sits in our coverage
Our internal consensus target for 2025 yields hovers around 1.075, with an acceptable range identified between 1.04 and 1.12. The following firms have relevant targets: - jpmorgan: 1.10 (Mar-26) - bofa: 1.04 (Mar-26)
While jpmorgan aligns closely with our target, bofa's lower forecast indicates a divergence of thoughts, specifically suggesting that our estimates sit at the upper end of the observed market spread.
How other firms see it
Firms such as jpmorgan see value in maintaining a bullish outlook on fixed income given the anticipated adjustments in policy, whereas bofa represents a more cautious stance, suggesting potential downside in the yields.
The shifts in U.S. Treasury yields will be crucial to watch, especially as adjustments to Fed policy and inflation expectations play out, which directly interlink with the trajectory of the EUR/USD currency pair and overall market dynamics.
01Fixed income markets are entering a transformative period as we approach 2025.
02Yield movements will significantly be influenced by central bank policy adjustments.
03Investors are advised to strategize around identified vulnerabilities and opportunities.
04Differing forecasts across firms demonstrate the variability in market expectations.
Market implications
Key levels to monitor will be the 1.075 mark in yield projections, as any confirmed policy shift by the Federal Reserve could alter expectations. Upcoming economic indicators related to inflation will also serve as critical calibration points for fixed income positioning.
Risks to this view
A reversal in this call could emerge if inflation drives central banks towards more aggressive tightening measures, pushing yields beyond 1.12 and altering the risk/reward profile dramatically. Additionally, unexpected geopolitical developments could create further volatility in fixed income markets.
ubs
Hi everyone, Dan Cassidy here. Welcome back to the Fixed Income Conversation Corner Series podcast here on the UBS Market Moves podcast channel. For today's conversation, we are excited to welcome back from our partners at Columbia Threadmill Investments, the Global Head of Fixed Income, Gene Tenuzo.
Gene is joined today by Leslie Falconeo, Head of Taxable Fixed Income Strategy for the Americas with the UBS Chief Investment Office. So Gene, Leslie, thank you both for spending some time today with our listeners, our clients. Leslie, I know you'll lead today's conversation with Gene, so let me go ahead and pass it over to you.
Welcome back. Thank you, Dan, and thank you, Gene. We always enjoy having you on these podcasts, and I think the timing is actually perfect for this one as well.
So thank you so much for taking the time and doing this with us. I know our clients and advisors are interested to know what you're thinking. So why don't we just get right into it.
Gene, as we know, the December FOMC leaned a bit hawkish. So we had that end of the year move hiring rates with the unexpected cut of the expectation of future Fed fund, the future Fed fund rate. But more importantly, I really also really want to think about or want you to have your thoughts on the 100 basis point move we saw since the September 50 basis point rate cut or around 100 basis points in nominal and real yields, a couple of things, like what do you think of higher yields here in terms of investor demand, and why do you think they've occurred?
There's this argument of it's growth, it's inflation, it's deficit, it's needing more term premium. Just what are your overall thoughts on the rise given the 50 basis points cut in September since then, and also just the investor demand that you think we're going to have going forward given these higher yields? Yeah, thanks a lot, Leslie, and Dan, thanks for having us on.
It's really remarkable what's happened in the bond market since the middle of September. The Fed has taken short-term interest rates down by a percent, and the 10-year Treasury has gone up by about a percent. So it's actually a 200 basis point steepening if we just think about the Fed's policy rate to further out the curve.
That's pretty remarkable if we think about other periods of Fed easing. You have to think about, well, what got us to this situation, and it has a little bit to do with what expectations were back at that time, and also what expectations are now. Look, the Fed was in an interesting position when it decided to cut and even start with a pretty noticeable cut of 50 basis points back in September, but the reason they cut is very different than the reason, or even the inverse of the reason, that they started hiking in 2022. 2022 was all about inflation.
The cut in 2024, the starting of that process, was really about the labor market, and Powell was very clear about that in his Jackson Hole speech and leading into the cut in September and the subsequent additional cuts later in the year, but I think what ultimately happened through the course of the year, one, maybe the Fed took out a little bit of tail risk. It comforted markets. It comforted financial conditions to have rates a little bit lower.
But two, we just didn't see additional further deterioration in the labor market come to fruition at least over those few months from the first cut in September till now, and so the Fed feels better about the economy. I would say the economy is fine. I hear a lot about U.S. exceptionalism and growth acceleration.
I think those are going a little bit too far. I would say the economy, by most aspects in terms of growth, demand, inflation, is really kind of back in the zone, meaning the zone of where we were pre-pandemic, where we were kind of shortly after the financial crisis. I wouldn't necessarily call it robust, but it's also not obviously decelerating or certainly not a recession.
So I think when you put all that together, there is more risk premium in the market. The market was probably a little ahead of itself with how much it was expecting in terms of cuts back when the Fed got started, but now the tables have turned, and we're at a point where we just had a 10-year auction earlier this month. That was the highest yield 10-year auction since 2007, or as I like to say, the last time the Treasury borrowed at that rate, Donald Trump was a Democrat.
So it's been a while since that's happened, and if we look at the value proposition with yields above the rate of inflation acting as a better diversifier from a correlation perspective, we actually think the prospects now are better than they were when the Fed started cutting. You know, and I think you bring up a really valid point, because people, the investors, have a tendency to forget that in September, when they cut 50 basis points, the terminal rate at that point in time was about a 2.8, say 2.85, right? And it's completely shifted.
Now we're around, say, a 4% terminal. So when we think about how the Fed is going to proceed going forward from the mentality that they had back in September of 2024 was, you know, they're being preemptive, you know, we can cut because the Fed funds rate and the effective real Fed funds rate was so high and very restrictive, to now would be, you know, we should cut, meaning that going forward, you know, that as they have this potential pause, they're going to look at the data, and if they cut, there's going to be a reason why they're doing it. So it's not necessarily a hard landing, but maybe some, you know, move towards their target of inflation or a little bit of instability in the labor market.
And I know from our perspective, we're thinking that the Fed still has two cuts to go in 2025, you know, 25 basis points in June and 25 in September. How do you sort of see the Fed's path from now to the end of the year? Yeah, I think it's not a straight line, but I do think the Fed can beat market expectations, meaning I think they can cut more than the kind of the not even two cuts that are priced in right now.
And I think there are plenty of scenarios where the Fed cuts, let's just say a full percentage point, because I think that would get them closer to what is neutral or what at least they forecast as neutral, right? Not necessarily what the market's pricing as that terminal rate. But let's sort of rewind a little bit.
I think really what the Fed wants is optionality, right? So, you know, in 2022, at the start of the hiking cycle, when you have 9.1% inflation from a CPI standpoint and 0% rates, the direction of rates is clear and it's upward. If we rewind six months, the Fed was looking at an unemployment rate that had risen from a 3.4% low up almost a full percentage point to 4.2.
History says once the unemployment rate starts rising at that trajectory, it's really hard to put the genie back in the bottle. So I think that's why they started cutting. But the unemployment rate's been stable since then.
And so that's a good thing. And they simply want optionality. And that optionality, I think, is to react to anything that happens in the economy, but very specifically policy from a government perspective.
Yes, we've had four years of a Trump administration already. I think that is informative and we shouldn't forget that. But, you know, some of the critical policies that are being discussed impact both sides of the Fed's mandate, right?
So from an inflation standpoint, tariffs are front and center. Tariffs cut, you know, a few different directions. Yes, they can be inflationary.
But if we look at the first four years of Trump's first administration, inflation averaged 1.9%. And imported goods weren't the biggest portion of that. We also have immigration policy that can play a role when we look at the labor market, which is only growing about 1.4% on a year-on-year basis.
That's decelerated notably over the last four years. So if you potentially risk some labor market growth from the immigration side, that could impact the job market and the economy, too. So the Fed's just looking at those variables and saying, we want the ability to go either way rather than commit to up or down.
But if I sort of step back and look at the gradual cooling that we see in most parts of the economy, I still think the more likely path is lower. So I'd be betting on 50 basis points as a base case, as you said. But I think the skew is more likely to be lower than higher if we think about those tail outcomes.
That's a definite—I mean, I think that's what's going to be interesting about this year as well, particularly when you're dealing with the data-dependent Fed, is that we're going to have a little bit of interest rate fall, right? I mean, besides the fact that we don't know exactly what those policy implementations will be, and we're going to get to that in a second. But with some of the interest rate fall even that we saw in 2024, you know, fixed income spreads.
We just think about fixed income as a whole, particularly the corporate credit side. And we've seen incredible compression within fixed income and also very little spread volatility, right? So when we think about how we enter, you know, 2025 with this optionality that, you know, we may have and the fact that, you know, some—and again, we'll get to the policy changes in a bit.
But just how people are positioned, you know, given the fact that cash doesn't have the same amount of yield starting 2025 that it did in 2024. How do you—how are you seeing your positioning right now, or how are you looking at the overall fixed income market as a whole, whether or not it's, you know, just get the carry, whether it's diversified among various regions? I'm just curious as your thought process.
Yeah, absolutely. I think when you first approach bond markets in general, you look at the total yield, right? So you might be buying government bonds, but more likely clients are buying corporate bonds or mortgage-backs or munis.
And so, like, the total yield is sort of the value proposition. And, you know, on the surface, that looks pretty high, at least relative to the last couple of decades. But when you break it down, as you pointed out, the risk-free rate component is elevated, but the credit spread looks pretty tight.
And, you know, credit spreads reflect, I think, a reality that, at least on the corporate side, corporate America is in pretty good shape, certainly in large-cap companies. And when we do, you know, look at the bottom up with our 70 credit analysts, what we see is that, you know, corporate margins are very healthy. They're near decade highs.
We see leverage at very low levels, which is, you know, very encouraging from a bondholder perspective. And, you know, one of my colleagues on the credit side just told me that, you know, last year, 2024, was the highest ratio of credit upgrades to downgrades from a credit rating perspective. So, you know, these things are not a secret, and credit spreads, you know, we can say they're frothy.
I would say, rather, they reflect a strong corporate fundamental backdrop, and that's a good thing. But if you say, okay, you know, what do I think around that, there can be a lot of dispersion. And if I, like, migrate a little bit from the investment-grade market to the high-yield market, we're not calling for a huge acceleration in defaults.
Defaults have been pretty low. We think they go up a little bit, but maybe to the kind of 3% to 3.5% per year range. That's not crazy by any historical standard.
But over the next two years, we think the dispersion across companies and industries is going to be dramatic. And actually, our internal forecast calls for, you know, some industries to be very, very low, if any defaults, like energy, like some of the insurance industries within high-yield, which is a huge change from the past. But other industries within high-yield, like media and telecom, we forecast over the next couple of years to be above 15% default rates.
So you just need to be really careful in this environment of spread compression. And, you know, you asked, you know, I think you used the word cash. And certainly we've seen across a variety of client types that cash balances are still elevated.
And I think clients still like the fact that they can earn something positive in money market equivalents where they had such a long period of zero interest rate policy. However, I go back to that first part of our conversation where we talked about, yeah, the Fed took rates down by a percent. Long-term rates went up by a percent.
All of a sudden we have what feels almost like this awkward position as bond investors. We have a normal upward sloping yield curve now. So what that's telling me is you're being paid to stay invested in the market.
You shouldn't be sitting in cash and money markets. I think if you're looking at short-term or intermediate-term alternatives, you can earn 5.5% in high-quality assets. That's a lot more attractive than money markets, even if you want to be fairly defensive from an interest rate standpoint.
So I think you should be invested out the curve. But I would say from a credit selection standpoint, you just have to be pretty selective given what we think could be a little bit of a bumpy road from an industry-by-industry dispersion perspective. Well, I mean, I think that's a great summation, particularly since when — and we have to agree with you completely on the cash side.
But, you know, with that said, we know we have quite a bit of uncertainty ahead. Just to some of the policies, you know, that — potential policies, I should say, in regards to, you know, the chatter about 25% tariffs on Mexico and Canada. And we know that they're conducting, you know, specified reviews.
They're going to be out, you know, April 1st when it comes to this America First trade policy. How are you seeing some of these sort of — or potential implications, if you will, to the fixed-income market as a whole? And, you know, again, when normally uncertainty — one of the things — in normal times of uncertainty, people go to the fixed-income market.
But now in this time of uncertainty, people might stay in cash a little bit longer than they should. So how do you sort of see some of these policies impacting or potentially impacting fixed income? Yeah, I think from a tariff standpoint, that feels like it's front and center.
I would say, you know, for one, we need to think about the value chain of tariffs getting into consumer prices. And they certainly can. And we've seen it in very specific industries and product types, no doubt.
But the first thing, you know, that happens is we think about who's importing the goods. Sometimes it might be the individual consumer, but often it's a company or a retailer. And I just mentioned margins are very elevated from a historical standpoint.
So some of the tariff increase can be absorbed by corporate margins. That's the first line of defense. The second line of defense is, well, what about the value of the currency, the exchange rate?
Because to the extent that the dollar appreciates — and it actually has appreciated pretty meaningfully in recent months — well, that acts as a disinflationary force, where even though there's a tariff on the particular good, it's actually costing less in dollars. So to some extent, that offsets. So you have those two mitigating factors.
And then once the good is imported with the tariff at the new exchange rate, after the retailer decides how to price it, then we have to look at, you know, how big is that in the consumer basket? And actually, most of the driver, or to the extent there's been a stickiness factor in inflation in the last year or so, it actually hasn't been on goods or certainly imported goods. It's been on services and things like housing.
So really, these are indirect impacts. All of that being said, we can't ignore it. And we have to recognize that just like we did see goods inflation from supply chains during the pandemic drive CPI higher, we can have those impacts.
So, you know, for us, we're taking a kind of a wait and see approach. But I think the comforting factor is that this is not 2022. And what I mean by that is our starting point is the Fed policy rate is just about 2 percent, almost 2 percent above the rate of inflation.
It was 9 percent below the rate of inflation back then. So there is a cushion. And that cushion means from a bond market perspective, you know, you're you have some a little bit of a margin of margin for error there.
So I think it's important to watch that whole value chain from tariffs play through to inflation. I would say that the other critical thing outside of tariffs from a policy perspective, Leslie, that we're watching is just the overall size of deficits. And this is something that I think has been a growing concern for the bond market.
We often hear about bond vigilantes. And really, the truth is, if you look over 40 years or so trying to build an investment model or a trading model correlating deficits in the U.S. to when you should buy or sell U.S. treasuries, it doesn't work. I've tried it.
It's not very effective. There's not a good historical correlation. But I would say that over the last two years, we have observed an increasing frequency of times when treasury yields have risen on news about the deficit or treasury supply.
And I think that's a growing concern now that, frankly, the total aggregate debt load is much larger. And the largest buyer, the central bank, is not a buyer at this point in time. So I think we have to watch very carefully.
The market is attuned to sensitivity around growing deficits. And I think to the extent that we see from a tax cut perspective or other policies from this administration, the expectation of growing deficits, I think the most vulnerable part of the yield curve is the 30-year part of the yield curve. And that's why we've seen some of that weakness and some of that steepening there.
So to me, you mix it all together. I still feel comfortable that in the kind of 5- to 10-year part of the curve, we have some decent value from an income perspective and a diversification benefit perspective. But to me, it's deficits and tariffs that are top of the list when I follow the policy progression of this administration.
I think that was a great summation. And I'll tell you, one of the things that we've discussed as well, first of all, we're also around that 5-year area of the yield curve. We've highly recommended and been quite negative to that back end of the yield curve, actually almost since the summer with the expectation that the yield curve would normalize after being inverted for two years.
And just in terms of how we viewed the fact that term premium was so low. But I will say that when we think about the deficit and supply, we always, to your point of running, trying to pick your point, when you look at deficit in terms of buying treasuries, we always view that and supply as a passenger, not a driver. Meaning that it's growth and inflation that lead, and the supply side is actually secondary, except if you're in a situation where growth comes out much more than anticipated.
And you have an unexpected increase in supply, like we saw in that October 2023 time period when we hit that 5%. And that's really been our view overall. Not that we don't pay attention to the deficit or supply, of course we do.
The market's well aware of this and we think the market's priced it in a decent amount given the amount of rise in term premium that we've seen over the past six months. But you kind of answered the question in terms of pockets of vulnerability. But I do want to ask you that question again, besides what we talked about in terms of potential back end and deficit and obviously the fear of re-acceleration of inflation.
But what kind of pockets of vulnerability do you see over the next year? And more importantly, what would be the opportunity or where in terms of do you see the value within fixed income? Yeah, first of all, I like the way you kind of framed that up in terms of the way you're thinking about treasury supply.
I think that's an absolutely reasonable way to look at it. In terms of vulnerability, look, we're not making the case that you have to buy into a recession thesis to buy fixed income here. And that's not our base case.
I think vulnerability is just more in the areas of the market where you maybe aren't paid for, but I'll just call some of the sharper edges. So if I look at the investment grade corporate market, fundamentals are great and I don't fundamentally have major concerns. But if you're buying a lot of 30 year investment grade corporate debt, if those spreads widen by less than 10 basis points, you can lose a year's worth of carry.
Or you can underperform treasuries very, very easily. So to me, it's just about looking at some of those asset classes where you have a lot of really long dated debt, what we call long spread duration. That would be things like investment grade credit.
It would be like emerging markets where there's just a lot of 30 year debt out there and it's already priced pretty tight. We just simply avoid those areas. We like areas that have more of an intermediate spread duration, but you still get a nice credit spread.
And so on the high grade side, I would say that the two areas that we like, one in particular is MBS, particularly agency mortgage backed securities. But I do think there are opportunities throughout the structured product landscape where you can get a percent to a percent and a half more than treasuries, which is about double what you get on the investment grade corporate side. And you have a less spread duration.
You're just not you don't you don't have that that level of potential volatility. I was pretty surprised today when I saw that the mortgage backed security government guaranteed market was yielding about five point three percent, which is almost exactly the same as the corporate credit market, which does have some degree of default risk to it. So we just simply like that trade for a for a similar yield.
Also, on the high grade side, we like the tax exempt market. I know several investors may not mix the two, but I do think from the standpoint of where we are from a tax equivalent yield perspective, particularly at the long end, if there is an area where you're going to go to the long end, for me, it's beauties. I wouldn't do it in corporate.
I wouldn't do it in other taxable sovereigns. But I think in beauties where you can get that even steeper yield curve, we do like that side. And then I like to kind of mix in one asset class, which I would describe as sort of the the higher for longer home run trade might be a little bit too optimistic.
But I think about the floating rate bank loan market as one where, again, as part of the broader high yield market, there will be dispersion. There will be winners and losers. But the starting point is pretty decent in terms of an overall yield above 8 percent and no interest rate sensitivity.
Definitely credit sensitivity. But in that camp of higher for longer through U.S. growth focus and potential deregulation, I think that's a nice yield additive asset class where I would say, look, if you're if you're expecting a recession, it's not the asset class for you. But if you're still invested in the stock market, why not consider some leverage loans that, you know, an 8 percent starting yield?
I would I would argue that over a five year holding period, you're going to get equity like returns there. So I kind of mix that together. And you have a diversified portfolio with not too much interest rate sensitivity, but really focus more on the intermediate part of the curve, a decent amount of yield.
And to me, I would posit that after the S&P has been up 20 plus percent in back to back years, that a portfolio like that's going to be pretty competitive and also be a nice diversifier. Now that we've seen correlations improve. Well, Gene, I tell you, you know, we are we are very much in sync.
And that's good to hear. We also like agency MBS, kind of meeting market attractive and like senior loans as well as a diversifier. And as I mentioned earlier, we are positioned around that five year curve.
So, you know, I think we have a lot of similar similar views, which is great to hear. And again, I do appreciate so much you being on this call. And I look forward to having you on the next couple of months that we could talk about how we did in terms of our outlook.
Absolutely. Yeah, that'd be great. So thanks so much.
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