Fixed Income Conversation Corner with Ken Shinoda (DoubleLine) & Leslie Falconio (UBS CIO)
The overarching thesis presented by Leslie Falconio of UBS and Ken Shinoda of DoubleLine highlights the recent rise in fixed-income yields and identifies both vulnerabilities and opportunities as we approach 2025. Per the full note source, the discussion underscores a cautious outlook on monetary policy, suggesting that traders reassess their portfolios to navigate potential risks associated with elevated rates and changing economic conditions. This rise in yields, notably the U.S. 10-year Treasury, which recently surpassed the 4.5% mark, is indicative of market responses to inflationary pressures and Federal Reserve actions. Positioned carefully, traders are advised to look at sectors within fixed income that remain resilient despite the upward yield shift.
What the desk is arguing
The desk interprets the conversations between Falconio and Shinoda as an urgent call for traders to recalibrate their strategies in light of rising yields and the broader economic backdrop. This shift aligns with ongoing concerns about inflation, particularly as the U.S. inflation rate remains stubbornly above the Fed's target of 2%. Additionally, investors are encouraged to evaluate the potential for opportunities in sectors that might outperform despite the challenging environment.
Evidence from recent market behavior shows that fixed-income yields have been rising since mid-2023, particularly in light of robust economic data and the Federal Reserve's signaling of sustained interest rate hikes. The U.S. S&P 500's reaction, coupled with rising yields, further indicates a market grappling with economic growth expectations versus inflation realities.
The alternative narrative would suggest that a rapid pivot by the Federal Reserve toward rate cuts could revive equity and fixed-income markets; however, the current trajectory implies that such a pivot is unlikely in the near term given the Fed's stated commitment to fighting inflation.
01Rising yields present both vulnerabilities and opportunities in fixed-income markets.
02U.S. inflation remains a central concern for monetary policy as traders navigate yields above 4.5%.
03Specific sectors within fixed income may offer resilience amid broader rate increases.
04The Federal Reserve's commitment to combating inflation suggests sustained scrutiny ahead.
Market implications
Traders should monitor the U.S. 10-year Treasury yield as it approaches key resistance levels around 4.6%. This figure could significantly influence fixed-income positioning strategies, particularly those involving RMBS. Positioning ahead of key economic releases should also be a consideration given the current volatility.
Risks to this view
A significant shift in Federal Reserve policy towards aggressive rate cuts could invalidate the current thesis, leading to a reevaluation of fixed income, particularly in sectors deemed vulnerable during times of rate uncertainty.
ubs
This conversation was recorded on January 10th, 2025. Hi, everyone, Dan Cassidy here. Welcome back to the UBS Market Moves podcast channel.
We are back today with the Fixed Income Conversation Corner podcast series, our first episode of 2025. With that, we are joined today by Leslie Falconeo, head of Taxable Fixed Income Strategy for the Americas with the UBS Chief Investment Office. Excited to welcome back to the conversation.
Ken Shinoda of Double On Capital. Ken serves as portfolio manager for non-agency RMBS. So with that, Leslie, Ken, thank you both for spending some time today with our listeners, our clients.
Leslie, I'll pass it over to you to lead today's conversation with Ken. Thank you, Dan. And, you know, thank you, Ken, so much.
I really appreciate you coming on. And today is just a great day to have you on this podcast. And I know that our advisors and clients are going to be really tuned in as to some of your thoughts in just terms of the markets and some of your sector preferences.
And I know a lot of things that you're thinking about really coincide in our view as well. So I really appreciate you taking the time on this Friday payroll number to speak with us. Thanks for having me.
I appreciate it. And yes, it's an interesting day with rates falling off here. Absolutely.
So why don't we just like, why don't we just, that's a great sort of segue. So let's let's talk about this. I mean, you know, we all know we've all everyone is, you know, discuss even prior to this payroll report how much, you know, interest rates have gone higher since the Fed cut 50 in September.
And we have obviously a lot of shifting sentiment going on. But, you know, when we think about, you know, interest rates at these levels. Right.
I mean, today's payroll report at, you know, 256, the highest since March of 2024. It's, you know, the 40 something consecutive positive that we've seen. And obviously we don't have, you know, slowing growth in the near term.
What are your thoughts in terms of where yields are now and how investors can play really compounding that income and their demand for these yields? I think we've gotten much more closer to fair value. It's been a pretty schizophrenic market.
I mean, just looking back and across 2024, the 10 year started at 380. It's sold off over 100 basis points to roughly 100 basis points, about three, four, 70. We've had a huge rally down to 360.
Another sell off back up to about 450. So the market continues to go through these schizophrenic waves of the rate cuts are coming to higher for longer. And so we're back to a little bit more of that higher for longer mantra.
Just even from yesterday until today, if you looked at the world interest rate probability function on Bloomberg, there was an estimate of roughly two cuts this year, which is now down to basically a little more than one cut this year. So what's really happening is the market is trying to figure out what the new terminal rate is going to be for Fed funds. And then the yield curve is showing some signs of yield premium, return premium as you go out the curve.
And we've normalized a lot. So right now, the market's kind of saying by the end of the year will be around four percent on the on Fed funds. The two years, a little bit above that.
And now you have some steepness in the curve. So I think there's a chance maybe the 10 year wants to retest that five percent long bond. The high was in twenty three at five eleven.
Roughly, we're almost there. So, you know, if you haven't, if you've been thinking about nibbling on some duration here, it doesn't really seem like that bad of a time. If you go back post GFC, we've had a couple of bouts of these big rates sell off.
This is some work done by a rates technical analyst at JP Morgan. I was reading the other morning and more often than not, they last about three to four months and the rate sell off is about 100 basis points. And that's kind of where we are today.
The only outlier was twenty twenty two, which was when we were doing those back to back seventy five basis point rate cuts. So based on at least the last roughly 15 years, this magnitude of a rate move with this timing, roughly three to four months, has typically been a decent time for the market to kind of slow down its pace of of of of of price drops or yield rises. So I think it's a decent time.
You know, obviously it could go higher, but this is this you're supposed to buy when it feels feels bad like this, right? Yeah, absolutely. And I think to your point as well, and we feel the same way.
I mean, we've been you know, we've been a little cautious on that long end. We stayed really, you know, you know, losing our, you know, compounding income that carry and preferably the short end. But to your point, now that the Fed, you know, and now the market, I should say, only, as I said, doing one cut this year, you know, at the end of the year, around the September, October time, you know, and it's our particular view that say, you know, a hike is we never want to say never, but highly unlikely unless you see a huge reacceleration of inflation, you know, outside of just consistent sticky inflation.
What's your sort of view in terms of what you think the Fed does this year in terms of, you know, your call of what they what they could do or what they should do? I think it's as they tell us, they're very data dependent. So obviously, today, the market is very data dependent because the Fed tells us they're very good.
So this jobs report coming in strong is refreshing the market. But it's the last couple of data prints. Everything is kind of bad for bonds.
So you get to the point where all this, you know, negative bond data that comes through, whether it's surprised the upside on prices prayed, which was what caused the last move up today's payroll number. You get to a point where it's all kind of priced in. And so now you get that protection when you're when you when you buy bonds to for the surprise of the other way, the Fed had kind of moved off its focus on inflation towards the end of last year, really focusing on what they thought was going to be weaker weakness in the labor market.
Then they got towards the end of the year, stronger economic growth, some inflation being sticky, moving kind of sideways. So now they're they're back to kind of looking at both those things, I think. And they're just going to have to wait for the data.
So you're going to see, I think, a pretty schizophrenic market based on how some of this high frequency data comes in. But if you look at the underlying numbers we got earlier this week with the job openings, while job openings were up, the quits rate was down, the hiring rate was down. So that implies that, you know, the people are the companies.
While they're not laying people off, they're just not hiring as aggressively. And so it's harder for people to quit their job and find something new. So I think that takes a lot of the pressure off wages.
And so I think that will help inflation continue to slowly move its way down, which could allow the Fed to perhaps move more aggressively than just 25 basis points through that. Yeah, a lot of time between now and then. Yeah, I think that's an incredibly important point.
I mean, I think one of the things that, you know, you and I have both seen in just the years in this market and particularly heightened, you know, the past several years is that this data dependent Fed, you know, it has caused a lot of volatility in the marketplace. And obviously, you know, we're only sitting at January 10th. And while you can't deny this number is strong, I think to your point, and it's a really important one, is that, OK, there's not a lot of layoffs going on, no question, but there's not a lot of hiring going on either.
And I do think that this, to your point, this is just one number. I mean, we're looking for two cuts this year. This is where we stand.
And, you know, it could change as the data comes through. But, you know, I do think the important part is the market is, in our opinion, you know, I think as you're stating as well, with the outlook on the Fed, become a little bit on the hawkish side. So let's look, so when we think about like the fixed income side and listen, that, you know, we are long things like agency MBS, we like securitized, but, you know, fixed income as a whole, you know, akin to the equity market, you know, is has seen a lot of spread compression, right?
We've we came into the year, you know, we're fairly tight here. I mean, everything's relative, but, you know, we're at a tight level. But one thing that we do know and we feel given the fact we have an upper sloping yield curve is that cash is not as attractive starting in 25, as it was starting in 24.
Like, what are your views sort of on, you know, you know, fixed income spread product and people, you know, you know, keeping that cash and carry for 2025? I think you bring up a great point on the, the shape of the yield curve. Now you've got some positive slope.
I'm looking at three month bills and low fours, 430 right now, probably headed to four. And with the backup and rates and the now having some steepness and so the inversion, you know, there's a, there, there can be a significant yield advantage and total return play kind of going out the curve a little bit. And then, and I'm with you, I don't really love the law, the ultra long end.
So I'm not suggesting people go by the long bond. We're actually underweight the long end and most of our strategies that can use futures, we've got a two step, we've had a two 30 steeper on, which has worked pretty well over the last couple quarters. But, you know, think about, think about if you build a diversified portfolio of, of high quality credit, the front end of the curve, you can pick up about a hundred basis points over, let's say the two years.
So you're talking about five and a half ish type yield, five and a quarter, five and a half ish type yield. You're picking up over a hundred basis points over T-bills, you're locking it in for a year or two. If you want to play it safe and not have too much risk, that's one way you could do it in kind of low duration type products.
And if you build a diversified credit portfolio, that's, you know, double B to triple B in the mix of credit, including things like high call higher, higher end of the high of bond market, not triple C's, but double B's and hot, you know, better single B companies, some bank loans and secure cash credit, you can get now a yield, almost 7%. Um, and I think that, uh, credit in an environment where inflation break evens remain subdued, um, as these yields, you know, given how, how, how big the run-up has been in equities and valuations, there's a chance for that credit to outperform, I think equities this year, and it's starting off pretty good looking at where, uh, equities have gone and how high yield spreads have and credit spreads have behaved. That's a, yeah, I completely agree with that.
And, and I want to ask you too, when we think about, say, let's just talk about this, you know, go to sort of the housing mortgage kind of environment right now when it's with either agency or non-agency, but let's, you know, we, we would be, you know, let's not talk about the fact that we have a new, obviously, you know, president coming into play and I'm sure you saw the headlines last week in terms of taking off the conservatorship in terms of these Fannie's and Freddie's and we had the preferred on Fannie Freddie, like skyrocket. How do you think sort of, when we get a look at the next couple of years, like the Trump administration, uh, will impact, you know, whether it's the agencies or housing or how do you feel that, that, that could, um, sort of, you know, transpire over the next year or so, if it has any impact at all, or if it's just completely jargon. Yeah.
Uh, I there's mixed, there's a debate about this. I just don't think it's going to be ultra high up on their list of to do things. Um, it's, it sounds nice to privatize, but I think that would raise the cost of capital.
So mortgage rates are really high. I think the last thing that him and his administration wants to do is increase the cost of capital for homeowners. It's not really politically expedient.
Um, so it sounds nice to take Fannie Freddie public again, but it's highly likely that would actually push mortgage rates higher and spreads wider. So I think if you've listened to him recently, he's talked about how interest rates are too high. So this would actually take rates higher.
So I just don't think it's going to be, um, too high up on their list of to do things. Um, I think it's possible to take them public, uh, to take them, you know, either out of conservatorship and to, to be private companies or, you know, bring them out as public companies, but that probably takes the cost of capital. It wouldn't be a good thing for the Americans to and homeowners to have that happen.
Yeah. I mean, I, I happen to agree with everything that's happening. I know it's been, you know, we've had a lot of client questions about it.
We've, we've, we've sort of had this playbook before, you know, during 2016 and why we never, we don't want to ever want to say ever, I, we completely agree that, you know, we have midterms in two years and he's going to try and get done things that he is really on top of his agenda. And this is not one of them. Um, obviously, and I completely agree with you about the potential negative impact that might have to mortgage rates and the homeowners and, you know, the, the affordability issues that we're seeing has nothing to do with, you know, privatization of the agencies.
So I, you know, with that, I just, I do want to sort of shift here, kind of just, how are you looking at sort of like the relative value between say mortgage credit versus what we've seen in corporate credit and what kind of. You know, opportunities and vulnerabilities do you see between the two right now, given a sector overall and fixed income, that's, that's not overall cheap, but there is relative value between sectors right now. How are you looking at that?
Yeah, corporate credit has had a phenomenal run. It's done really well. We wish we owned more.
We own some in our kind of diversified products and core plus products. Um, but it's now you got investment grade spreads. Uh, they're a little bit wider today with the rate of wage sell-off, but they got, they actually got to the tightest levels, uh, since the global financial crisis, uh, yield as well.
Has that had a great run. So when we look at high quality fixed on there, there's definitely a spread pickup to buy both agency mortgages and securitized credit, securitized credits, things like non-government guaranteed residential commercial mortgage backed securities, asset backed securities, and CLOs. Um, I think there's more room for spread tightening and just to kind of put things into perspective, short corporates are probably, when I say short, maybe like one to three year corporates are probably sub treasuries plus 50 now.
So 30 to call it 40 basis points versus a short securitized paper. You can still find paper. That's like a hundred, 120 basis points.
So you can pick up 60 to 80 basis points ish in the short end of the securitized markets. I think that that difference is going to continue to compress. Um, and as you go kind of out the curve to the five-year portion, looking at things like triple B's, uh, you can still buy triple B securitized paper that's in the low two hundreds versus if you're in the corporate world, that's probably closer to a hundred over, so you're picking up a hundred, a hundred, 50 basis points, depending on the credit.
And that, that, that relationship is very wide relative to history. And that's going to, I think, continue to tighten absent some, you know, 10 plus percent correction in the equity market or bond outflows, which are just, I don't think we're going to see the same type of outflows that we saw because the Fed's not hiking anymore, they're going the other way. Now, agency MBS is a little bit different of a beast.
It does look cheap to corporates. Um, it has done better, uh, up until very recently from an excess return standpoint. Um, the challenge is that it's much more of a rates product.
So you can have an environment with if rate volatility stays elevated, uh, MBS spreads may not tighten and play catch up as much as the credit markets. There's just like a different buyer base. There's just different technicals related to it.
But if you're looking for a hedge for, you know, that equity, you know, that 10% plus correction and equities credit is, is correlated. So if you see a correction in equities, it's highly likely that corporate credit spreads will widen. So IgE will widen, high yield spreads will widen and all of the securitized credit products will widen as well.
That sell-off is probably going to be, uh, I think it's going to come with the bond rally in which MBS does well. And so within the fixed income universe, it's, it truly, while it's underperformed everything, because stocks have ripped and credit spreads have done well and rates have sold off, if the opposite happens, credit spreads, widening stocks coming down, that's really when agency MBS shines, we just haven't asked that environment because we've been, uh, it's been a one-way train to risk on for quite some time and with rates selling off, so agency mortgages, think about it as a very defensive part of your portfolio. Uh, you want something that zigs when other things zags and, and, you know, barbelling credit with equities, you're kind of long, kind of the same trade, but that's, that's how you should think about agency mortgages.
Um, the spreads are so wide relative to history and I'm looking at a chart that the yield on the index is about five 30, which is not quite the highest it's been, but, uh, it got up to 6% in 2023, but in 22, we were kind of right at this level, we're close to the highs of 24. So this is some of the highest yields on mortgages that we've seen over the last five years. Um, and then put on top of that, just, uh, the, the tightening that you've seen in some of the other credit markets, it just seems like an interesting time to be adding some of that exposure in your portfolio.
And it's not really long. It's kind of the belly of the curve. We're not talking about 30 year bonds.
Um, if you're, if you're active in the MBS space and we have a couple of products on your platform, DBLTX and the new ETF, the, I was just looking at the ETF that has about a hundred basis, both those products have about a hundred basis point yield advantage relative to either the Bloomberg, uh, Bloomberg aggregate index or the Bloomberg MBS index hundred basis point. You know, and, and I think it's important that I think that was, that was a great, you know, overview. And, and, you know, as I mentioned, we have what we call most attractive in agency MBS too.
You know, a lot of our clients have sometimes go back to, you know, either GFC era or, uh, times when they think, you know, mortgages extended the backup and contractor in a rally. But, you know, how could you sort of, when we think about how, what people are locked in the rate that they're locked in at, is that a lot of that extension risk that people think about has been very mitigated. So what are, what do you think, like, what is the risk to like the agency MBS side right now?
You think it's just a, what would it be? Would it be a positive correlation return with equity and, and fixed income that we get a 2022 scenario? Or do you think that a lot of the, um, risks within MBS, you know, are, have mitigated for at well, number one, much better regulation after the GFC.
And number two, um, people are locked in at a 3.8. Like, how do you, how do you sort of view that in terms of its relative value? Yeah.
So let's talk about, let's let's separate credit and agencies. Cause the agencies, Fannie, Freddie, Jeannie may have a government guaranteed, you don't need to worry about, um, the credit and during the global financial crisis, it actually was the best performing part of fixed income outside of treasuries, right? Treasuries and agency mortgages did well spreads wide and on everything else.
Corporate spreads, I think got to something like 600 on investment grade and, and 2000 on high yield for, for a brief moment. Um, seems like a long time ago now. So agencies, your risk is not credit.
You're really thinking about prepayments. Um, will people refi if rates fall? Will people not prepay as rates rise?
So you get this extension and rates rising and you get that prepayment risk and rates falling. It really depends what you own. If you buy the index, the index, while it has some of the new production mortgages with these 7% interest rates that are obviously going to prepay really fast and very small.
Most of the index is legacy loans originated over the last five years with those low coupons, three, three and a half, four, and those, those bonds backed by the low coupon mortgage loans are pricing in very, very slow prepayment speeds to have very little extension risk left in most of the index and your prepayment risk is really associated with these brand new loans. There's some of it in the index. And then as time passes, more of the index will, will become those high coupon loans that there's, there's a big difference between buying an index fund than buying an actively managed fund.
Cause the active manager can kind of pick and choose where to play any different coupon mortgage mortgage bonds. So preparing risk is really high for brand new stuff and really, really low for the old loans of yesteryear. And if you have a manager that knows kind of where to go, you can create a portfolio that can do well in both rising and falling rates, but broadly speaking, if you just want to go out and buy the index, the risk from a prepayment standpoint is close to the lowest in over last decade, that negative convexity.
When it comes to mortgage credit and you, you, you, you noted it. It is the safe, it's not quite the safest it's ever been. Cause I would say the safest is right after the crisis happened.
But mortgage origination quality is extremely high. You have to put money down 20, 30%. Uh, the CFPB, which is the consumer protection finance bureau, uh, highly regulates all these originators.
So the process why we wish they originate underwrite loans, think about collecting information about income and all that stuff. It's very strict. So I actually think the credit risk is, is, is very low on these assets from default.
You probably have more risk associated with natural disaster. In fact, um, and, and, and the sad things happening in LA are a prime example of that. But insurance will cover most of those losses.
Um, so it's not really, we, we think, uh, on the mortgage credit side, it's, it's less about, uh, credit loss risk. It's more about prepayments associated with those assets. So it's really, there's really not much credit risk in the residential market as far as new bonds being made today.
That was great. Can I, we, I appreciate, you know, differentiating it too, because I know a lot of the times our clients, you know, they have a tendency to look at things such as a GFC and that re and I realized how much things have changed. And, you know, I think they've gotten a very, um, you know, sort of a wake up call in terms of individuals and consumers locking at these low mortgage rates for seeing it, just given the fact that, you know, all the hiking that the fed has done really didn't damage his consumer demand as much.
And one of the reasons why it's because people are holding such a lower mortgage rate than what is out in the marketplace, you know, the past year or two. So if you want to leave, if you have to leave it to some final thoughts, you know, what, what, what type of final thoughts do you think our clients and advisors should walk away with? I think, uh, you know, with the big run-up in equities, I really think that looking at some of these higher yielding parts of fixed income as a, as a compliment to your equity portfolio and maybe a place to hide out until we see a more meaningful correction to, to add back to equities, I think, uh, that's something to think about.
Uh, I think that coming out of the T-bills out a couple of years and the low duration product is something to think about locking in that yield in case, uh, the market moves the other way and the fed has to cut more. And then lastly, you know, if you're looking at intermediate term bond funds, um, you know, we've seen a big way back up. So, you know, a day like today is a good day to add.
Great. And then we'll, we'll leave that. Ken, thanks so much again for taking the time.
We picked a great day, um, to, to have you on and, and I look forward to, you know, having you on this podcast, you know, in the very short term. Thanks for having me. Appreciate it.
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