Top of the Morning: Fixed Income - Resilience, recalibration, and remedies
In the context of shifting fixed income landscapes, the desk frames the current market environment as one undergoing intense recalibration, driven by hawkish rhetoric from Federal Reserve Chairman Kevin Warsh. Per the full note , these comments signal a potential tightening bias that could influence currency valuations, particularly for USD pairs. With markets bracing for year-end monetary policy adjustments, traders should remain alert to interest rate expectations which are subject to change. Overall, understanding these dynamics is crucial for positioning in FX markets, particularly if fixed income assets continue to respond to Fed communications and economic data releases.
What the desk is arguing
The desk believes that recent hawkish comments from the Fed are pivotal in prompting a repricing of fixed income assets, which will ultimately impact FX dynamics. Leslie Falconio from UBS highlights the consequential nature of these shifts, suggesting that they signal an impending recalibration in market expectations for interest rates, something FX traders must monitor closely.
As the market navigates through this recalibration phase, traders should note that perceptions of tightening monetary policy could strengthen the dollar across various currency pairs. The anticipation surrounding Fed Chairman Warsh’s comments could foreshadow further adjustments in fixed income positions and, subsequently, influence FX trading decisions.
Where it sits in our coverage
Currently, the consensus target for USD pairs sits at 1.075, with forecasts published by several reputable firms indicating a range from 1.04 to 1.12. Specific targets from jpmorgan (1.10) and bofa (1.04) offer a strategic contrast, particularly as traders look to align their strategies with these expectations.
The desk's view, leaning towards a stronger USD due to potential Fed tightening, appears to align closely with jpmorgan, and is positioned at the upper bound of the existing consensus distribution. This alignment suggests that if Warsh's hawkish tone is successfully leveraged in the markets, it could provide additional momentum for the dollar appreciation.
How other firms see it
In this shifting landscape, firms like jpmorgan and others are aligned with the view of a stronger dollar amidst Fed tightening expectations. Conversely, bofa presents a more cautious outlook, suggesting a lower limit target for USD pairs.
Traders should also monitor closely how these dynamics play with key currency pairs such as USD/EUR and USD/JPY, as their movements may reflect broader macroeconomic trends driven by Fed policy adjustments and fixed income volatility.
02Upcoming adjustments in monetary policy are expected to significantly impact FX markets.
03USD strength is anticipated as interest rate expectations are recalibrated.
04Traders are advised to align strategies with possible mid-year Fed decisions.
Market implications
Traders should keep an eye on the dollar's performance against key pairs, particularly USD/EUR and USD/JPY, as they may respond sharply to evolving Fed signals. Attention to positioning adjustments in the fixed income space can also provide insights into FX market movements moving forward.
Risks to this view
A sudden shift in Fed policy, particularly towards a less hawkish stance or unexpected economic indicators suggesting slower growth, could invalidate the current bullish stance on the dollar. Such developments would likely force traders to reassess their positions in FX markets.
ubs
Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.
Today's conversation will focus back in on fixed income. We will spend some time highlighting the latest fixed income strategist publication from the UBS Chief Investment Office, the title, Resilience, Recalibration and Remedies. Joining me here today for the conversation, glad to welcome back to Top of the Morning, head of taxable fixed income strategy for the Americas from UBS CIO, Leslie Falconeo.
Leslie, great to be with you on this Wednesday morning. Thank you for dropping by. Thank you for having me.
So, Leslie, to get into the publication, which in part does cover a second half outlook for the asset class. We will cover that a bit later in the conversation, though, to begin, do you want to touch on recent market conditions and how they have impacted the repricing and recalibration of fixed income assets? I'm curious as to what you've been picking up on, what's been taking shape in recent weeks?
Yeah, I mean, we sort of titled it this, you know, Resilience, Recalibration and Remedies, and that was the title of the piece. We titled that for a number of reasons. One is that, you know, obviously this recalibration that we've seen in the market's projection of the Fed fund rate took a dramatic shift from the 60 basis points of cuts that was priced in at the end of February to now, you know, maybe about 50 basis points of hikes priced in through 2027 today.
But what's interesting is that the market has been incredibly resilient in terms of the consumer, in terms of, you know, the equity market, and even in terms of spreads. And I know Dan will get into that in a second. But what you're looking at is just this sort of, you know, push me, pull me as to when the market is anticipating the first hike to occur.
I mean, last week we had Waller speak on, you know, that Monday, he came out a bit hawkish. The market thought that we'd have a 50% chance of hiking at the July 29 Fed meeting. Now that's down to about 15%.
But given the fact that we've seen this sort of reacceleration of the conflict in the Middle East, you know, we're grappling with, you know, for example, Dan, like WTI crude, you know, jumped to say 88, a little over 88, a little over 88 and a half overnight. But remember, in the beginning of early July, it had fallen to 67. So when we look at how this change in oil or this conflict impacts, you know, fixed income expectation, inflation expectations and interest rates, we always said the conflict had to do about duration and magnitude, right?
So we have the duration. Now the magnitude isn't as great because we saw oil prices, you know, much higher a couple of months ago. But still that change that we're seeing from say the 67 to 88 is fairly large.
Now, one of the things that has, you know, occurred in our opinion that I want to reiterate from the CIO point of view, we don't think the Fed hikes this year. You know, we don't. We don't have it on the table.
Obviously, we don't say that with 100% confidence. You know, it might be a 60-40s kind of split because we don't know a lot of these, you know, ramifications that we're going to have from oil. But we do know that mostly the Fed has a tendency to look through supply shocks.
And although inflation has been above target for a very long time, we're not seeing a large, you know, rise in wage inflation. And a hike right now, in our opinion, really wouldn't do anything to be enough of a headwind for the right reasons to bring inflation down. So we've had this sort of this push me, pull me, which has moved interest rates higher.
Again, I mean, we saw the two-year yield go, you know, 427, 430, that's the highest. And since 2025, it's a high year to date as they put in these hikes. We saw the 10-year move to the low 460s, not the high of the year, but on that path.
So what we're seeing is just this market sort of react to stronger growth expectations, resilience of the consumer, right, the tailwind we've seen from AI. I mean, some of it is an inflationary component, but overall, the good contribution to growth, the resilience of the equity market, but a point of concern going forward as the Fed really focuses on the price stability side of the mandate. Leslie, as you outlined for us, a lot of factors top of mind for fixed income investors, including, as you mentioned, the Fed.
It was interesting, investors were surprised to hear the hawkish commentary delivered from Fed Chair Kevin Warsh during his first press conference. What will the Fed be focused on near term, let's say through the balance of 2026? And what might these focuses or mandates of the Fed mean for the interest rate environment going forward?
Yeah, I mean, you know, one of the things that we weren't as surprised with the hawkish tone, I think there would have been a credibility issue there if he would have come across a little bit too dovish. I do think this hawkish tone sort of stays in play, however, because when you have a hawkish tone, what that does, Dan, is that inflation expectations and the long-end stay anchored are actually come down. And that's really what sort of, in a sense, the market is looking for.
And you're seeing this, by the way, through real yields, you know, real yields in, say, the 30-year sector as some of the highest that we've seen since, you know, 2008. And partly this has to do with growth, partly this has to do with supply, and partly has to do with the long-end inflation expectations are coming down. So that hawkish sort of rhetoric wasn't necessarily a surprise to us, because it does keep that long-end in terms of nominal a little more sort of subdued.
You know, we are looking for, at the end of July, not so much, obviously we're not looking for a hike, we're not looking for a hike this year, but we do anticipate that he will have more of a hawkish tone. But one of the things that I think the market really needs to watch out for is that, you know, the press has a tendency to cherry-pick certain things, and it might make them sound overly hawkish than what it is. Now, I will say that the market has a tendency to lead the Fed, and what I mean by that, Dan, is that when the market gives a green light, right, saying, hey look, I'm pricing in a hike, I'm pricing in a two-hike, but we think this economy's still doing fine, right, then they're kind of telling the Fed what they should be doing.
And that's normally how it works. The market leads, the Fed reacts. In this situation, however, because of a lot of this uncertainty, at least for 2026, right, I don't think necessarily the Fed is going to hike just because the market's giving them a green light to do so.
I think they need more data, I think they're going to need more data on the labor market, I think they need to wait until some of these supply concerns start to wean. Obviously everyone keeps their eye on gasoline prices, the fact that they've gone up, but I just don't think that the market is going to necessarily be in a situation where the Fed says, okay, you're giving me a green light to hike, therefore I'm going to hike. And I think that's one of the situations we have to go in going forward.
Now, in terms of how we think about year-end, we do have a slowing outlook in the second half of the year, not below trend, not anything that's going to be sort of a fall in terms of concerns over growth, but a lot of this cushion from tax returns, a lot of this cushion, whether it be from even some of the tariff refunds or some of the fiscal side, is going to sort of start to wane. And we think that especially in the lower part of that K, it will start to pull back, consumer spending starts to pull back in the second half of the year, and we see some slower growth. Again, not like what we're going to price in for February of this year, but we do believe that that slower growth will bring 10-year treasury yields down to around that four and a quarter level, leave the Fed on hold for the year, and really wait till it gets more data and feedback, by the way, about these task force that he set up, which is not going to be to the end of the year before actual Fed action starts to take place.
In terms of performance expectations, Leslie, if we now turn to the second half outlook portion of our conversation, talk to us a bit about the factors that will drive return in the second half and anything top of mind that could perhaps spark volatility that you're being mindful of. Yeah, I mean, the volatility part, and we've written about this, we do anticipate volatility. You're seeing it, right?
Particularly when it comes to shifting expectations of Fed moves, right? Like I mentioned to you, Dan, I mean, when Wallace spoke a week and a half ago, they had a 50% probability that they were going to hike in July. That's now down 15%.
So volatility is definitely going to be in play. The fact that this, the conflict in the Middle East has lasted much longer than was anticipated, that there's still a lot of uncertainty regarding hyperscaler issuance and its impact on credit spreads that we've seen, and frankly, its impact on long and real yields. But I do want to point a few things out to your question, Dan, which I think is important, is that one of the things that we wrote about, well, two things we wrote about, is that given all the volatility we've seen, risk asset spreads have been very contained, right?
Spreads are rich. Duration's cheap. Interest rate risk is cheap.
But spreads are rich, right? But spreads, not only are they not a good predictor for future total return, right? They just are not the driving component.
It's the yield that you're earning is a driving component. And one of the things that we did in the piece, two things that I really wanted to point out that we calculated. One was, you know, if we look at the projection of total returns to December 2026 and June of 2027, which is about a year, you know, we forecasted the total return given our expectation on spread and on the U.S.
Treasury yield curve. And given it's in fact, we included our defaults and recoveries assumptions as well. And if you, when you look at that, you see that locking in these yields and compounding that income is your driver of total return.
And it actually looks very attractive, right? And we know that. We also know that fixed income has, you know, very much underperformed the equity market right this year, right?
There's no, everyone knows, we've got the equity market nearly all time high. And we've got the fixed income market that has, you know, in terms of total return, most assets are flat to slightly up, but nowhere near the equity. So we do think that going forward, fixed income will play this large part.
Now, one of the things that we also did, Dan, what I think is important is that we took, we tried to say in the what if scenario, it is not our view that the Fed hikes, but let's just say they do. What point in time can we go back to that serves as somewhat of a template and, and for fixed income, that is a lot of the street goes back to sort of like that 1999 hiking period one, because remember in 97, they hiked in 98, they ended up, you know, easing 75 basis points during a long-term capital rush, all these kinds of things that were going on that were headwinds to the economy. And then they took back that accommodation in 99 and started to hike again.
So what we did, we took that sort of that, we took, you know, five different periods of cycles of hiking cycles. And we think 99 is the most relevant. And we looked at six months before, six months after and 12 months after the initial hike of how fixed income has a tendency to, to, to perform and equity for that matter.
And as you see, and we're seeing this now, initially the yield curve will flatten, right, because the market's saying you're going to hike and that short end goes up and initially you get some pressure on total returns. But when you sort of move forward, what happens is as the Fed does hike, the market starts to take a step back and go, oh, wait, you're going to slow the economy. You know, we might have some issues going forward because fixed income is forward looking.
And then you start to these, these big recoveries, you know, it's just a few months out after the first hike. So I wanted people to take a look at that because I think it's important. And also too, you know, our, our, the drivers, there's no question is going to be the level of rates.
Okay. You know, we don't believe that spreads widen out materially. Yes.
Credit spreads could absolutely widen from these, you know, 25 year, 10 percentile levels, but we don't think that they're going to, you know, crater. We think the equity market holds up. Um, and we think the majority of your return is going to be driven by, uh, compounding income.
But again, the higher we are now, like that four 65 and 10 year treasury yields, now you're going to get some price appreciation, start to kick in. Cause we do think yields will be lower by the end of the year. We're staying in that two to five year, but extending around that four 60, four 65, a little bit after that seven year is not necessarily a bad play given our forecast for the end of the year rate.
Leslie against that backdrop with that outlook in mind, putting money to work, what are you recommending for fixed income investors as we're now gearing up for the second half? Yeah, we've done a little bit of a, first of all, I know this sounds very one-on-one, but it's very true. Um, we want to stay diversified.
The majority of our, of our placement, um, our interest rate exposure has been around that two to five year area of the curve. We've preferred securitized, you know, over say investment grade corporates. We have more neutral investment corporates with an attractive to like agency MBS simply because we like liquidity, the higher quality.
Um, there aren't supply concerns, but what we did then is that we've also recently, um, because especially in the U S we don't have a lot of, you know, corporate credit exposure, if you will. We just, we added high yield to attractive and you know, any high yield to attractive is not because while we're getting this great value spread because we're not right. But again, spread's not the best predictor of future total returns.
You know, we've got that because the, it's a short ass high class, high in a higher quality. Um, and the compounding income that you're getting is, is very, very strong in terms of, um, future total returns. So we, we've added that.
We also like the short end treasury side. So right now we have a combination of a bit of higher quality in the two to five year and also taking some, what we call that short end, uh, carry in the credit market with, with the U S high yield. And I think that's how we're going to play it most likely for the end of the year.
And as I, as I mentioned, it's very difficult to know exactly what that 10 year point is given the volatility we're seeing as in the Middle East conflict. But I can say is that if say you break that high that we've seen in four 68, 10 year, we don't think it's going to be sustained. Could a C four 75?
Absolutely. We don't think it's sustained. And we buy on that dip for interest rates to move lower by the end of the year.
And that, that remains our play. We've just had some, you know, obstacles that we've had to go over just again, the uncertainty of the conflict, the uncertainty of a new fed chair and fixed income speculation that fairly convinced the marketplace that the fed is going to hike this year. Again, CIO is looking for an on hold fed strategy this year.
Well, Leslie, as always, very helpful touch base to hear your expectations and positioning guidance for the second half of 2026. Thank you for dropping by top of the morning this morning and look forward to our next conversation. Thanks, Dan.
I appreciate it. Thank you for tuning in. Be sure to visit UBS dot com slash studios to view the entire UBS studios suite of podcast channels, along with our video offerings such as UBS trending.
You can also follow us on Instagram for content highlights at UBS trending. UBS studios is part of the UBS chief investment office within UBS global wealth management. Visit UBS dot com slash CIO to view the latest research.
UBS chief investment offices, investment views are prepared and published by the global wealth management business of UBS AG or its affiliate UBS. This material has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is published for informational purposes only as a firm providing wealth management services to clients globally. UBS AG and its subsidiaries offer both investment advisory services and brokerage services, investment advisory services and brokerage services are separate and distinct differ in material ways and are governed by different laws and separate arrangements.
In the USA, UBS Financial Services Inc. is a subsidiary of UBS AG and a member of FINRA SIPC for information. Please visit our website at UBS dot com forward slash working with us for a full legal disclaimer applicable to the independent investment views produced by UBS. Please visit our website at UBS dot com forward slash CIO dash disclaimer.