Top of the Morning: Fixed Income Strategist - Back to school prep
Lead — The desk emphasizes a cautious yet optimistic view on fixed income strategies amid potential Federal Reserve rate cuts, supporting a diversified asset allocation. Per the full note from UBS, the anticipated economic adjustments suggest a significant further easing of policy, with expectations of up to 100 basis points of cuts starting in September. The backdrop of a labor market imbalance, along with demographic shifts, creates a complex environment for fixed income. This sentiment aligns with broader market expectations, suggesting that strategic positioning will be critical in navigating upcoming volatility.
What the desk is arguing
The desk believes that the recent shifts in labor market dynamics and the anticipated Federal Reserve actions create a favorable backdrop for a diversified fixed income strategy. Per the full note from UBS, there are projections of approximately 100 basis points in rate cuts beginning in September, which underscores the potential for lower yields ahead.
Furthermore, the payroll data reflects an ongoing supply-demand imbalance, compounded by demographic changes such as retirements and immigration patterns. This trend could drive future adjustments in investment strategies, particularly within fixed income markets.
Where it sits in our coverage
As it stands, our current consensus target is 1.075, with most firms aligning their expectations around this figure. The following are notable targets from specific firms: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
This positioning indicates that our view aligns broadly with consensus but sits closer to the higher end, reflecting an optimistic perspective in light of potential easing ahead.
How other firms see it
The prevailing sentiment among aligned firms like jpmorgan suggests a general optimism regarding fixed income strategies, while firms like bofa present a more cautious outlook, indicating contrasting positions on the impact of Federal Reserve actions.
Market dynamics surrounding the EUR/USD trajectory are worth watching, particularly as they echo the broader implications of evolving Fed policies, which may also influence other major currencies in response to anticipated rate changes.
What the calendar says
No high-impact events are scheduled in the immediate future, thus allowing market participants to digest the implications of the Fed's upcoming decisions without immediate external pressures.
01Expect a cautious yet optimistic stance on fixed income strategies.
02Anticipated Fed rate cuts could total 100 basis points beginning in September.
03Labor market dynamics will heavily influence fixed income market positioning.
04Diversification remains key in an evolving economic landscape.
Market implications
Watch for price movements towards the consensus target of 1.075, as markets respond to upcoming Fed rate decisions. A clear signal of sustained employed dynamics could further consolidate this positioning.
Risks to this view
A stronger than expected employment report or a significant shift in Fed communication could invalidate the current bullish stance. Additionally, any reversal in rate cut expectations would likely pressure fixed income assets and shift trader sentiment significantly.
ubs
Hi everyone, Carly Torres here, and welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today's conversation, we are focusing on fixed income strategy, which coincides with the release of the most recent fixed income strategist report from the UBS Chief Investment Office. For today's conversation, we will be discussing positioning considerations for the month of August, outlook for the asset class, and discussing some recommendations.
Joining me today for the conversation, I'm excited to welcome back Leslie Falconeo, head of Taxable Fixed Income Strategy Americas, and Barry McElindan, fixed income strategist, both from the UBS Chief Investment Office. Great to be here with you both today, and thank you so much for joining us. Thanks very much.
Thanks, Carly. This month's report covers a lot, all the way from the sector to the individual security level. So let's get straight into it.
Leslie, can you summarize the recent events in the marketplace, and what do you see for the remainder of the year? Sure. I mean, obviously, since the payroll report, we've had a lot of shift in sentiment in regards to what the Fed's path might be.
And right now, you know, they're pricing in about 60 basis points of cuts in 2025, about 60 basis points of cuts in 2026. So about five cuts in total. CIO anticipates about 100 basis points in total, starting in September, moving through to the first quarter.
Now, one of the aspects in terms of the payroll report, which we know, because the large revisions that we've seen, is that, and as Paul has indicated, there is, you know, this sort of demand and supply imbalance within the labor market, meaning that while we're not seeing large amounts of firing within the economy, we're also not seeing a lot of hiring, right? But with that said, we also have the labor supply coming down quite a bit. Part of it is demographics, people retiring.
Part of it is due to, you know, immigration. And one of the things that we note, even though we do anticipate a cut in September, you know, the cutting is not going to change the supply situation within labor markets. You know, cutting is not going to change, you know, what's happening with immigration in terms of supply or demographics.
So what the market's really looking out for is to ensure that, or might push against, if they do cut and we do have, you know, inflation re-accelerate, you might be in a situation where that back end starts to move higher. Now, we have a yield curve steeper on, meaning that, you know, whether you're bullish or bearish, you know, we think that short end outperforms the long end. You know, over the long term, we're definitely looking at, you know, things that are bullish in terms of interest rates, because we do believe this Fed cuts, you know, methodically.
And so, therefore, we think interest rates can go down, but we're staying in that intermediate part of the curve, that five year, because of the fact that we think, you know, we want to wait until we extend our interest rate risk. You know, maybe it's about a 450, 460, there's no question that the economy is slowing in terms of both, you know, soft and hard data, but we don't want to rush into extending. So we wait, we're going to extend, because we think ultimately yields will go lower.
And as Barry will get into in a minute, most of our, you know, positioning has been in the higher quality. We've definitely seen that this high quality sectors have outperformed cash. We have, during points of time of the year, pushed against being overly defensive, because we do have the equity market continuously reaching these highs, which have pushed lower credit quality higher.
But again, that diversification that we had, right now, in terms of where we are, we're really sticking with more of that high quality, like IG, agency, MBF, and treasuries. Lots of moving parts. Thank you so much.
And Barry, what are some of the foundational elements that you review as part of that report theme, Back to School Prep? Yeah, Carly, so some of the elements are overall yield. And you know, we were talking about how attractive the yield environment is in fixed income.
And it's actually been attractive now, believe it or not, for like the past three years, since the Fed started raising rates in 2022. So you have to go back further in history before rates, you know, are kind of below the averages of where we've been today. But we still think that, you know, yields are going to be attractive for investors, and the main appeal of the asset class.
This is important for both kind of the longer term perspective, because income is a primary component of the total return you can expect in the different fixed income sectors, over longer term holding periods, like 12 months, three years, five years, etc. But it also provides a buffer in the short term, in terms of, you know, how much yields would have to rise before you lose the price and offsets it, that's called the breakeven analysis, you would have a flat total return. So we, you know, we kind of just refresh this theme, this is something that we would talk about quite a bit on our team.
But the breakeven yields are high as it relates to the different sectors, progressive grade bonds over the next six months, it would take a 39 basis point increase in yield to produce a flat total return. That's the 70th percentile over the past 20 years. And even for high yield bonds, because of the high income of 7% and low duration of three years, the six month breakeven is 119 basis points, which is about the 89th percentile over the past 20 years.
So you know, that buffer exists in the marketplace, which we think is quite important, especially because spreads, as we know, you know, do remain historically tight. And look, we think that the environment warrants the tight spread, which I'll get to in a second. But I think, you know, you can't bank on excess returns coming from spread compression going forward.
But you can, you know, bank on that income, that kind of excess carry is what we think, where you see the value in those high quality sectors that Leslie mentioned, like investor grade corporates, and agency MBS. And also, just, you know, fundamentally, you know, we're coming off of kind of a corporate earnings season that was, you know, pretty strong in the second quarter, where profits are growth of high single digits year over year. And perhaps more importantly, though, is that the guidance that companies were given for third quarter is quite constructive.
So you know, third quarter was a period when the market participants were thinking, you know, the effect of the tariffs could be, you know, perhaps a greater headwind to these corporates. And you know, based on the guidance and the revisions of earnings, you're not seeing that. And I think, you know, that's obviously helped support equity market levels where they are now.
But again, it's also kind of an underpinning behind why credit spreads are as tight as they are. And then finally, just on the technical side, so this is supply demand. The technicals are quite balanced in the taxable fixed income sectors.
You know, it's more the municipal side where you see the influx of supply, which has caused some underperformance in that sector. But as it relates to like investment grade corporates, these summer months were actually in a situation where you have negative net issuance, though there's more redemptions in the marketplace than there has been issuance. And then just as far as gauges demand, whether it be insurance companies or even foreign demand, you know, that's definitely been intact.
And then also just the unflow data. This past week, it was reported that high grade funds saw the fifth highest weekly inflow on record last week, totaling $11 billion. So generally been a constructive technical environment.
Now, look, these are factors that are supporting the credit asset classes currently. Obviously, you know, subject to, you know, some positive vulnerability could change this. But, you know, for the foreseeable future, we do see it's a pretty good time post that, you know, these factors and underpinnings should persist in the near term.
Great. Thank you. Barry, what are some of the reasons that you say fixed income will remain a desirable portfolio track?
Yeah, so the main reason is that even with the Fed, as Leslie mentioned, we think they're going to cut rates by 100 basis points beginning in September. You know, we're still at a Fed funds rate, a short term overnight rate, which is four and a quarter to four and a half. So there's there's room for that to fall by 100 basis points, or even, you know, if it goes a little bit further than that, let's say 125 or 150.
And you're still be in, you know, kind of that neutral Fed funds rate level of about three percentage. So we think that is important because, you know, an upper sloping yield curve environment further out the curve, you're going to earn a yield that's a little bit higher than that. So, you know, this this more attractive yield environment, even with a Fed cutting rate, is likely to persist.
And especially as that short end moves lower in yield with the Fed cutting, I think this demand to lock in higher yields on cash should continue. And that's really why we think that fixed income should be a desirable portfolio track ahead. I think like for investors, it means that you shouldn't necessarily have to like really search, you know, to find yield.
I mean, I think it's going to be there even in these high quality sectors. Yes, you know, we think you should come down somewhat, but still be, you know, appealing, I think, from an absolute basis going forward. Right.
So finally, Leslie, what is our portfolio positioning in fixed income? Yeah, I mean, I think Barry covered, you know, well, how much compounding income is going to be the driver of total returns, given the fact that spreads are not cheap in those that are credit embedded, those that are high quality. I mean, there's the only really, I would say, two asset classes that fall into more of the relative value cheap category, agency MBS and munis.
Right. Both of them have been subject to a little bit of this interest rate volatility. Both have been subject to people staying on the sidelines in terms of demand, just given the uncertainty.
But we do look for those sectors to perform in the second half of the year. Now, you know, we are staying with the high quality in terms of things like investment grade corporates, agency MBS, and staying within that five-year area of the curve. But it won't be something that we do for, you know, for the next, we've been doing this since the beginning of the year.
It's worked out well for us. You know, the second half of the year into 2026, it might be a little bit of a different story, because really what we need to see and what we need to have some of these unknowns be known is how actually tariffs are going to impact some of this inflation. We got CPI this morning.
Yes, it's higher on the good side. Everyone's expecting that, but it's coming in a bit less severe than what's anticipated. So you have this temporary market relief, but that doesn't mean that it's over because it's just pushing it out further in terms of when this will actually flow through to the actual, to the system, to the fundamentals, which we anticipate it will.
So right now, we're not going to extend our duration too much. We're going to keep it that five year. We're going to watch to see if, in fact, the market gets overly aggressive in terms of their Fed projections, meaning that, you know, when we have the market price in too many cuts versus the Fed guidance, we've said this before, we have a tendency to push against that a little bit.
It's worked out well for us. You know, in the September meeting, we'll get a new SEP projection. We know that there's been some changes in terms of some of the Fed members, which is already priced in to be a little bit on the more diverse side.
So until we get a little bit more clarity, we're going to take that carry in high quality. We're going to stay in the intermediate part of the curve. And look, I mean, you know, IG corporates and most, almost all fixed income has had, you know, a decent, very good return this year.
So we can't, you know, we can't say anything about the return, but it's just one of those where spreads are a little tight. We're just going to selectively pick our carry and not get too over, not move down in quality too much at this time. And if you're going to do that, particularly you need to watch the correlations with the equity market.
You're probably better off in equity than you would in, you know, those credit embedded sectors within fixed income. So that's really our play from now to the end of the year. But obviously, we're subject to change because this is always, as we know, a changing marketplace.
And we just need to see how some of this data actually plays out. But we have some more inflation numbers, another non-firm payroll before the September FOMC meeting. Definitely a lot to look out for.
Thank you so much, Leslie and Barry. I encourage you all, our listeners and our clients of UBS to give this publication a read. Again, we've been referencing the report, Fixed Income Strategists Back to School Prep for the month of August.
Leslie and Barry, thank you for stopping by and sharing your insights with all of us. And I'm looking forward to our next conversation together. Thank you.
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