Top of the Morning: Fixed Income Strategist - Pushing the boundaries
The desk anticipates a continued adjustment in the yield curve, particularly as rate cuts from the Federal Reserve come into play. Per the full note from UBS, fixed income markets are likely to adopt a steeper curve as interest rates begin to shift, creating a tactical opportunity for traders positioned in the intermediate part of the curve. While UBS has highlighted the recent flattening trend, the underlying fundamentals suggest that a back to steepening dynamic is on the horizon. With limited impacts anticipated from high-impact events in the next month, traders should remain alert to any updates from the Fed regarding rate cuts, which could provide further directional cues.
What the desk is arguing
The desk frames this as a pivotal moment for fixed income positioning, given Leslie Falconeo's insights that anticipate a steepening of the yield curve due to expected Fed rate cuts. This expectation is anchored in the backdrop of a potential fiscal deficit and market positioning that has been reactive to recent flatter trends.
The desk relies on Falconeo's mention that while the long end of the yield curve has underperformed, investors are still advised to focus on intermediate maturities. Given that the yield curve was inverted for two years, this could present significant trading opportunities as the curve normalizes once cuts are confirmed.
Where it sits in our coverage
Currently, the consensus target for USD rates leans towards 1.075, with a range of potential outcomes identified by various institutional players. For Dec-26 targets: - jpmorgan: 1.10 - bofa: 1.04
This view aligns with jpmorgan, which anticipates upward pressure in its forecast, while diverging from bofa, which remains on the more conservative side of the range.
How other firms see it
Most firms, including jpmorgan, are aligned with the expectation of a yield curve steepening in response to Fed policy changes. In contrast, bofa holds a more cautious stance, reflecting concerns about lingering economic headwinds.
Relevant market dynamics, such as the USD yield curve and monetary policy adjustments, are expected to be influenced by upcoming Fed communications and the evolving economic landscape, particularly in terms of inflation indicators.
01Expectations for Fed rate cuts are likely to influence a steepening of the yield curve.
02Investment strategies may benefit from focusing on the intermediate parts of the yield curve.
03Market positioning has shifted, with traders encouraged to navigate the curve's recent flattening trend.
04Upcoming Fed communications may serve as critical catalysts for further movements in fixed income.
Market implications
Traders should keep a close watch on any Fed signals regarding upcoming rate cuts, with a specific focus on yields around 1.075 for actionable insights. Additionally, fluctuations around the 10-year yield could indicate the market's perception of risk and return in fixed income assets.
Risks to this view
The primary risk to this outlook lies in a hawkish turn by the Federal Reserve, indicating that rates may remain higher for longer than anticipated. Any economic data suggesting persistent inflation could negate the expected yield curve steepening and force a reevaluation of fixed income positioning.
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 UBS Chief Investment Office. For today's conversation, we will be discussing positioning considerations for the month of September, 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 from the UBS Chief Investment Office. Great to be here with you today, Leslie, and thank you so much for joining us. Thanks very much.
Appreciate it. Of course. So first, you've been calling for a yield curve steepener this year and it has worked out.
But over the past few weeks, we have seen the curve flatten. What has caused this and how do we see this trend into the end of the year? Sure.
And you're right. We've been calling for a yield curve steepener since probably the second half of 2024. Remember, this is after being inverted for two years.
And two reasons why we were calling for that was one is that, you know, we did anticipate that the Fed would start to cut rates, the market was expecting a higher probability of a red sweep, and all these were sort of this yield curve steepener kind of trends. And of course, we also had things such as the fiscal deficit that came into play. Now, our expectation was that the long end of the yield curve would underperform whether or not you believe interest rates are going up or interest rates are going down.
And we really kept in that intermediate part of the curve and we discouraged investors from extending because, you know, at that point in time and for most of this year, we've been looking for the steepener. And to your point, over the past couple of weeks, we've seen that the yield curve flattened. It's flattened because we saw it, we were seeing this long end coming down.
But it's important, two things to note. One, the bond has underperformed tremendously this year, right, versus the other parts of the yield curve. Two, given the Fed's focus on full employment and a little bit of labor cooling, you know, the yield curve is pricing in this really slow growth kind of environment.
So it's bringing down that long end on top of the fact that inflation, while above, has been four years above the Fed fund target, it really hasn't come in as strong as what forecasters were expecting, you know, given sort of this tariff flow through. Now, when it comes to going forward, I have to say we still are in the steepening camp. I mean, we're seeing, we do believe growth will cool, right, but we're not looking for a recession.
While, you know, the back end of the yield curve has had the benefit of not that much supply as the, you know, refunding has been in the short end of the yield curve, we just believe that this sort of flattening due to slower growth is a little bit overdone. So you know, we do have a longer term steepener. So the trend's in place, you're seeing a little bit of a hiccup, which is what to be expected given the magnitude of the move, but we think that steepening trend will continue over the next several months.
Great. Thank you. What have been the drivers of investment grade outperformance, and how do you see this developing into the end of the year?
Yeah, we've been, you know, we've been a proponent of high quality for quite some time. We've had a high quality allocation in both IG and Agency NDS for, you know, almost a couple of years now because of the fact that our view was growth was going to slow, spreads had gotten very cheap, and more importantly, we were able to lock in carry or yield for a high quality asset and start to compound that income, and you know, as we know, fixed income, it's in the name, it's about income. And so when we look at these sectors, why we stay with the high quality was simply because one, there's several points in time where we prefer the equity market over fixed income, number one.
You know, number two, you know, our view was that spreads would compress, and there wasn't really any reason to take on that extra credit risk when you're getting paid yield for high quality. And what are the drivers have been, I mean, we've had, first off, as we know, as money market funds reach record high AUM, a lot of people are in cash or cash alternatives. They're still sitting on the sidelines.
You know, we've had supply in the marketplace, but it's really been with alongside large demand both foreign and domestic, and of course, going back to the equity market, the equity market has done well, and it's really helped, you know, tighten in things like corporate spreads. Now, when you put on top of that the fact that Fed is going to cut, the market is looking at loose financial conditions and a lot of tailwinds for the sector. So what role is the Federal Reserve playing in today's bond market, and how are investors reacting to expected rate cuts?
Melissa, there's been, obviously, a very big highlight in the Federal Reserve in terms of some shifts in governors. Obviously, there's always the headline risk that people like to talk about with Fed independence, even though there's multiple, you know, there's several people, you know, within the Fed. But I think that the difficulty right now and why the Fed is in such a spotlight is you have a point in time where the economy is softening a little bit, and while inflation is not, you know, moving up materially, it hasn't gone away.
So you have the Fed that's at a tough crossroads. Now, you know, after Jackson Hole in August, there is a consensus that the Fed will cut, and they'll go cut on Wednesday. The market's expecting that.
What the market doesn't know is what the surrounding commentary will be along that cut. And in the fixed income side, this fixed income is forward-looking. Fixed income likes to speculate, so they're pricing in about 150 basis points of cuts.
That's a lot. That's aggressive. And, you know, the Fed, while committing to the cut, in our opinion, in Jackson Hole, he didn't commit to, you know, a series of consecutive cuts.
And that's really going to be based on what we see in the economy. Now, we know the labor market is loosing, but there's things. Retail sales today was strong.
Atlanta Fed GDP now is at 3%. So this is not an economy that's creating, it's simply cooling. So we look for 25 basis points.
You know, the market is just expecting consecutive cuts after that. It might be a little bit premature, even though that might be the ultimate path, but the way that it's pricing in, it might be a little bit too fast. So I think that what he will say is that he'll cut, and I don't, and I personally believe that he's going to keep the data dependence framework.
How are agency mortgage-backed securities performing this year, and why are they becoming more appealing to investors? You know, agency MBS, they've, there have not been a lot of sectors within fixed income that you could say offer a lot of relative value from the standpoint of where spreads are, right? Not necessarily yields, but spreads.
And agency MBS was one of those sectors that lagged, say, their high-quality counterparts like investment-grade corporates. Some of the reason had been because the unknowns regarding political policy, whether it was privatizations of GSEs and all this type of, you know, headwinds to performance, and they really started to lag. However, the past month and a half, agency MBS spreads have really, we want to say, kicked in in the sense that not only have they, the spreads compressed, but given where they're located in the curve, that's also been a tailwind to total return.
So now you have a sector that is still cheap. So I have something like agency MBS that has spreads at a three-year tight, while investment-grade corporates are at a 25-year tight. And that's the difference.
And also, too, with things like agency MBS, I have higher quality, I have higher liquidity, and when it comes to their current coupon, I'm picking up yield. So because, as I said, the equity market has done so well, those corporate credits have kind of moved along with that outperformance. And those things like agency MBS were lagging, but now we have, we've seen some sponsorship in regards to, you know, what might happen going forward in the commitment to lowering the mortgage rate, we've seen a lot of this deregulation in bank demand, a lot of hedge fund demand, a lot of REIT demand, and finally, we've seen a sector that really has started to outperform tremendously the past month and a half.
We actually think that continues, because again, versus everything else, it's still pretty cheap, and you have, you know, a high-quality, you know, 5% instrument that really offers you good protection if, in fact, we go into a recession, right, because it is, this is quasi-government guaranteed, and also if, in fact, you know, rates should move up a lot, they have less interest rate exposure than, say, edgy corporates. So that's a sector that we still continue to like, and again, you have an opportunity set within fixed income, which is not broad, you know, like every other thing within, you know, the U.S. investment universe, you have to be selective, and obviously, we came into the year, you know, relatively rich, and it's continued throughout the year. So that's why we're looking at CNBS.
And finally, what's your overall outlook for the fixed income market over the next 6 to 12 months, and which areas do you find the most attractive? Listen, you know, we've had, when you go into the end of the year, most fourth quarters are subject to a lot of balance sheet window dressing, you know, because it's the end of the year, but we have a couple more valuables on this. We have potential government shutdowns, we have a November Supreme Court in terms of tariffs, and so there's a lot of variables heading into the fourth quarter, and all of these variables are coming behind sectors that are probably on the richer side.
So our expectation is you're going to see volatility at the end of the year, right, you know, we expect that. You know, we expect maybe even part of the first quarter, you might see a little bit of volatility, but we use that as opportunistic, meaning that you want to buy on these dips, and that goes for like the high quality stuff that we still have. It's not that we believe things like high yield or loans that are deeper credit embedded instruments are going to have this catalyst, we just don't find there's necessarily a lot of relative value there.
However, if they should cheapen, then we would be at it at that point in time. So we're not looking for an economy that's going to fall off a cliff, we look for an economy that's cooling, we still look for the Fed to cut, we still look for financial conditions to remain loose, and we still look for the capital markets to remain open, which is key. So given that liquidity, we still remain in things like, you know, agency MDS, securitized product, we think it will do very well, and we think IG corporates will still do fine, they're just not as cheap as they once were.
And when it comes to positioning on the curve, you know, we're staying around that intermediate part until, you know, we had a 4% year-on-tenure treasurer yield, we're at 402 right now, so we're almost at our target. So we need to be cognizant of, is the market rallying too much without weak economic data to support that rally? And if that's the case, then as things move lower, and if they do, you might want to take some chips off the table and just wait for a better entry point.
So we are buy on a dip if treasurer yields should rise, and we are buy on a dip if a fixed income spread product should widen. Perfect. Thank you so much, Leslie.
Thanks very much. Of course. 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 Pushing the Boundaries for the Month of September. Leslie, thank you so much 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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