Fixed Income Conversation Corner with Lotfi Karoui (PIMCO) and Leslie Falconio (UBS CIO)
The desk asserts that the current macroeconomic backdrop, characterized by higher fixed income yields, will lead to a strategic repositioning in credit markets, particularly in terms of corporate debt and widening spreads. Per the full note , there are potential implications for US corporate debt given the looming maturity profile amidst increasing yields, possibly reshaping the risk appetite in both fixed income and FX markets. The analysis suggests that this environment could foster tighter credit conditions and influence trader sentiment across various asset classes, including foreign exchange dynamics related to interest rate differentials.
What the desk is arguing
The thesis suggests that rising yields and a challenging credit landscape will create ripples throughout the FX market, particularly impacting currency strategies linked to US dollar strength and market volatility. According to Lotfi Karoui from PIMCO, there is clear evidence of widening credit spreads and concerns about the capacity of corporate borrowers to meet higher debt service obligations amid an evolving macroeconomic picture.
Support for this view comes from the discussion on the significant volume of AI-related bond issuance, which could affect liquidity and pricing in the credit markets. Karoui highlights that the US corporate debt maturity cliff poses substantial risk factors for broader financial stability, especially as businesses may struggle with refinancing in an environment of elevated borrowing costs.
Where it sits in our coverage
Despite there being no internal consensus targets currently available for the currencies under consideration, the general sentiment indicates that traders should remain vigilant about the correlation between liquidity conditions in fixed income and the valuation of currencies tied to growth metrics, particularly the USD.
How other firms see it
Aligned firms like jpmorgan maintain a bullish stance on the dollar amid expectations for continued rate hikes, while bofa expresses skepticism about the sustainability of dollar strength in the face of credit market turbulence.
For traders, the anticipated impact on the USD/EUR trajectory may reflect central bank policy responses, especially if the ECB continues its tightening cycle in response to inflation pressures, further complicating cross-currency dynamics.
Key takeaways
- 01Higher fixed income yields projected to influence credit spreads and risk sentiment.
- 02Increased issuance from corporate debt sectors poses refinancing challenges amid rising rates.
- 03Expectation of tighter credit conditions could have spillover effects on FX strategies, particularly for the USD.
- 04Traders should watch for developments in corporate debt maturities impacting liquidity.
Market implications
Traders should monitor the USD/EUR exchange rate closely for indications of strength against the backdrop of rising yields and credit concerns. Any correlation to significant corporate bond issuance may also provide early signals for currency valuation changes.
Risks to this view
A reversal in the desk's call could occur if the Federal Reserve signals a more dovish posture unexpectedly, or if the corporate debt markets stabilize and yield pressures abate, easing credit concerns.
Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show. He is a licensed financial professional both in the U.S. and Israel. Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA.
Accounts carried by National Financial Services LLC. Member NYSE & SIPC, a Fidelity Investments company. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com.
Call today to learn more about his book Building Wealth in Israel. Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com.
He is a licensed financial professional both in the U.S. and Israel. Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC.
Member NYSE & SIPC, a Fidelity Investments company. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show.
His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. He is a licensed financial professional both in the U.S. and Israel. Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA.
Accounts carried by National Financial Services LLC. Member NYSE & SIPC, a Fidelity Investments company. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com.
Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. He is a licensed financial professional both in the U.S. and Israel.
Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC. Member NYSE & SIPC, a Fidelity Investments company.
His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show. He is a licensed financial professional both in the U.S. and Israel.
Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC. Member NYSE & SIPC, a Fidelity Investments company.
His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show. He is a licensed financial professional both in the U.S. and Israel.
Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC. Member NYSE & SIPC, a Fidelity Investments company.
His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com.
He is a licensed financial professional both in the U.S. and Israel. Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC.
Member NYSE & SIPC, a Fidelity Investments company. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show.
He is a licensed financial professional both in the U.S. and Israel. Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC.
Member NYSE & SIPC, a Fidelity Investments company. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show.
He is a licensed financial professional both in the U.S. and Israel. Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC.
Member NYSE & SIPC, a Fidelity Investments company. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show.
His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. He is a licensed financial professional both in the U.S. and Israel. Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIFMA.
Accounts carried by National Financial Services LLC. Member NYSE & SIPC, a Fidelity Investments company. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com.
Douglas Goldstein, CFP®, is the director of Profile Investment Services and the host of the Goldstein on Gelt radio show. His book Building Wealth in Israel is available in bookstores, on the web, or can be ordered at www.profile-financial.com. He is a licensed financial professional both in the U.S. and Israel.
Securities offered through Portfolio Resources Group, Inc., Member FINRA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIFMA.
Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC.
Member FINRA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIPC, MSRB, NFA, SIFMA.
Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC.
Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIFMA.
Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC.
Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIFMA.
Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC.
Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIFMA.
Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIFMA. Accounts carried by National Financial Services LLC.
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Accounts carried by National Financial Services LLC. Member FINRA, SIPC, MSRB, NFA, SIFMA. I absolutely agree.
I want to go back just really quickly. And I agree with your assessment on the crowding out as well, 100%. Yeah.
But I do want to talk about some of this AI bond supply, you know, some of the headlines that we've seen, you know, only because, look, how do you view and we know they're fairly impervious to these higher rates, right, that we're seeing right now in terms of the projected ROI. But what do you think about this bond supply, how higher borrowing costs might influence the outlook if, in fact, rates keep moving higher or will that buyer start to step back a little bit that's been such a big driver of fairly contained spreads overall. Like what is your sort of thinking on that?
So, look, I think higher cost of capital kind of shifts the focus a little bit to the financing model. And I think it forces the market to look a little bit more carefully at any capital structure that requires a low cost of funding in order to justify sort of the enormous amount of investments that need to be made. And so there's no question that, again, you know, higher cost of capital is sort of part of the broader theme here, which is it pushes investors to naturally move a little bit higher in quality.
And I think that's true in the broader credit market and it's also true in the AI financing, you know, chain. So that's one point I would make. I think whether this sort of ends up slowing down the pace of CapEx, I really doubt it because, you know, this is one of those extraordinary times in my view where if you look back at, you know, the history of the last, you know, 100 years or even 200 years, I don't think there's ever been a time when the capital management or the capital spending decisions of a handful of firms could have such an enormous influence on the durability of the entire business cycle.
And so this is still pretty much a highly concentrated CapEx cycle. And so the question is, is this 100 basis point or so backup in the cost of debt enough to sort of slow down the pace of CapEx from companies that are still able to generate an extraordinary amount of free cash flows or cash flows, rather because the free cash flows are actually negative now. And I think the answer is no.
There's also a strategic element to this race that may sort of force you to accept economic outcomes that are, you know, slightly less compelling, but because it's a strategic race, you sort of keep going a little bit. So I'm skeptical that this will have a meaningful impact on sort of the forward trajectory of CapEx or the funding mix of that CapEx for that matter. And so to me, the question is still pretty much the same, which is it's not so much who will buy the debt, but it's at what levels basically this debt will be absorbed.
When I look back at the past 18 months, which is roughly when that transition from retained earnings to debt capital started. So meaning that was sort of the point at which hyperscalers kind of started to rely on debt in order to fund this CapEx. I think that gives you the answer, which is this sort of AI supply shock has been absorbed at its source a little bit because for now the market has been charging, you know, AI issuers more to issue new debt, but not the rest of the market.
And so I think that's the mechanism, I think through which this AI supply sort of will continue to be absorbed, which is most likely, you know, some, some additional risk premium in that AI financing chain, possibly, you know, some spillover to the broader index, but for the most part, I would say it's, you know, the market will continue to charge more. And the market, I think, because the market has more choice today, and because yields are higher, I think the market will probably gravitate naturally towards, you know, higher quality type of structure. So that's for the credit part.
I guess the other really important debate here is that where are we in that sort of AI compute cycle? I mean, you can make a very reasonable case that AI compute is pretty much sold out for the next two, maybe three years. And so the spot economics of say an AI data center, you know, looks great today.
The problem I think from a credit perspective is like, how will that, how will those economics look like, you know, three, four or five years from now? And if you look at most estimates of monetizations, the range of outcomes is incredibly wide. And as a credit investor, at the end of the day, you're just underwriting the leverage that is necessary for this infrastructure built out.
You don't capture any upside in a good state of the world. And so our message has been to look for structures that offer resilience, not in a good state of the world, but actually in a bad state of the world, because that's when you need to make sure that as a, as a debt investor, you're, you're, you're being paid back. And so from day one, I think we'll sort of never viewed this AI, you know, debt funded CapEx cycle as like one big trade.
There's enough differentiation across structures that, that, that actually, you know, creates a lot of dispersion and a lot of opportunities, but this is not one big trade. You really have to take it on a, on a deal by deal cases. And at the end of the day, focus on structures that give you that downside protection in a bad state of the world, because, you know, we're credit people, you know, the upside goes to shareholders in a bad state of the world, you know, and if you're just underwriting the leverage, you know, resilience and downside protection is what you need to look for.
And do you think, do you think that's why we've had somewhat of a dispersion between where say cash is versus what we call the credit default swaps or people buying protection, you know, hedging that out. Do you think that's one of the reasons why we've had seen this little bit of dislocation? Possibly.
Although I would say the dispersion theme kind of took a little while to manifest itself into credit. That's funny because if you look at the equity market, I mean, if you take the points of the, of the hyperscalers, it's been very dispersed for like a year and a half now. I think credit is sort of catching up a little bit and you're absolutely right.
You see it in the basis between credit default swaps and, and, and the bonds. Obviously there's a bit of a technical element there, you know, credit default swaps tend to be used by, you know, hedgers. And so sometimes hedging pressure can sort of exacerbate those relationships.
But yeah, that's one, one aspect of it. I guess the other aspect is to kind of cut it between, you know, look at the various layers of that AI financing chains all the way from senior unsecured hyperscaler debt to sort of Neo cloud. And if you look at the performance of the last month and a half to two months, it's felt a lot more dispersed, you know, than the prior sort of year or so.
And so I think dispersion is here to stay. Yes. So when, when we think about, you know, to the end of the year and, and into 2027, I could tell you, Leslie, from our view, from our CAO, we do believe the said hikes in December.
We believe this had hikes in March of 2027. And then by the near the end of 27, it starts to cut. And one of the arguments that was made last, last week as we had the stronger inflation number and yet, you know, 10-year yields went down, even though they went down, moving, you know, very quickly on the upside, you know, in a very short period of time was that, okay, the market's pressing in these hikes because we have this price stability component that's been a spotlight, but it's not the hikes that they, the market's looking that they're underestimating.
It's more that the market might be underestimating the amount of cuts needed. So what is it like at the end of 27 or how the economy really turns? How did, how are you viewing, you know, just, and, you know, what's typical thinking about this ad to the end of the year and just, and through 2027 too, and how might that impact your overall?
I think we broadly agree with your assessment, which is if you look beyond sort of the next couple of months, I think the direction of travel for inflation is probably lower. Some of that, by the way, is just mechanical because a lot of the one-offs that kind of, you know, pushed inflation higher in 26 and 25 will naturally sort of, you know, fade. Some of that should reflect, you know, hopefully some productivity gains and some sort of benefits from this, from broader AI adoption.
But we would very much agree with that. Now I also very much agree with you that the response of duration and treasury yields to, to the CPI, you know, miss was really interesting because you would have thought this is an upside surprise, you know, yields should have gone up, not down. And yet actually they did go down quite, quite materially.
I think there's a few possible explanation, you know, explanations there. One is, you know, the prospect of Fed sort of hikes eliminate again, that state of the world in which inflation expectations get de-anchored and the back end of the curve kind of start moving in a, in a, you know, on a, on its own plane. And so, you know, if anything, you're, you're, you're sort of eliminating that left tail risk where inflation gets out of control, that's supportive for duration.
I think the other driver or the other explanation, which is oftentimes overlooked is that this backed up in yields, that's got to restore the role of bonds as a diversifier in, in multi-asset portfolios. I mean, everywhere you look, you're being paid probably the strongest level of yield support in now 25 years. And we should expect that, you know, these episodes where we're going to see some pressure on, on equities, possibly like a five, you know, or 10% drawdowns, I think bonds will not only offer you income between now and then, but they'll give you pretty good protection every time you have, you know, you know, a little bit of a downward pressure on, you know, on equities.
But I think the big for bonds that we saw, you know, past, you know, two weeks, and you certainly see that in the flow data by the way is largely a reflection of a, of a new reality for multi-asset portfolios, which is that the math looks different. You know, the starting level of yields, you know, bodes well for the income generation ability of bonds and also the ability to provide protection in a bad state of the world. So with that said, I mean, just as final thoughts in terms of positioning, interesting.
How do you, how are you viewing the, you know, IG, high yield loans sort of allocation right now? And, you know, what is PIMCO thinking about in terms of trying to, you know, get that carry and, you know, compounding income and preservation of capital simultaneously? Well, look, the good news, I would say is that you don't have to move too much down in the quality spectrum in order to generate returns.
I mean, this is true. You know, in rates, this is also true. And, you know, in, in, in, in credit, I think this reset high in yields has completely sort of changed the forward outlook for, for total returns.
So that's to me, good news. Now they can have a little bit closer to home, you know, high yield versus leveraged loans. Obviously the loan market has some pretty pronounced sort of sector level compositional differences with the high yield market.
And so at the index level, you know, I think, you know, there's better quality and high yield relative to the low market. But I think that understates, I think the opportunity set, because again, most of the alpha generated capabilities are probably coming from bottom up work and doing sort of old fashioned credit work. It's interesting because we lived in a, in a 10 year period probably from the end of the global financial crisis, all the way to COVID where you really didn't have a lot of dispersion and, and you were paid actually reasonably well to just own the market.
We're not in that world anymore. And so, yes, at the index level, I would say the high end bond market has a bit of an advantage from a fundamental standpoint, also from a trade off between sort of carry and duration. But I think most of the opportunities really at the single main level at, at these levels, that's how it sort of characterized things.
Right. Okay. Well, listen, this has been, this has been a really, really great conversation.
And I, it'll be something that I know our advisors and clients will definitely have a, you know, get a lot of ideas and thoughts. And these are a lot of, we discussed a lot of what we've been made, what I've been being asked, I'm sure you as well over the past month or so. So thanks so much for coming on.
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