Bond markets are pricing in a hard landing where central banks have to cut rates extensively to avoid a recession, according to M&G Investments’ Eva Sun-Wai.
The rate-cutting cycle has officially begun in the US, with the Federal Reserve lowering interest rates by 50 basis points in September.
Although “not quite a doomsday recession scenario”, markets are pricing in “an awful lot of rate cuts” over the coming 12 months, the manager of the $881m M&G Global Macro Bond fund said.
“Bond markets seem pretty convinced that something closer to a hard landing is the answer with government bonds racing to price in front-loaded rate cuts and an easing cycle that is looking consistent with a near-recession-type scenario,” she said.
But does the data justify this? There has been some weakening in the US labour market recently, with unemployment rising.
However, Sun-Wai said broadly strong economic data is “painting a picture of a reasonably stable economy”. This, coupled with a stable dollar, suggests we could be heading more towards a no-landing or soft-landing scenario.
“I think it was important for the Fed to acknowledge that some data has come off a little, but I don’t think the 50 basis point move was necessarily a dovish one,” she said.
“We’ve moved from a pretty high starting point with restrictive rates to slightly less restrictive rates, but we’re still at a high starting point.”
The rate cycle has entered a new phase. Rather than being myopically focused on bringing down inflation, which is currently “broadly under control”, the Federal Reserve’s attention has shifted to the economy.
“Price levels are still high and the consumer still feels pretty uncomfortable [but] we are seeing some deflation in places, so we are entering a phase where the Fed is starting to cut to avoid this turning into a recession,” she said.
A soft or no-landing scenario, however, is not without cost. The combination of tightening monetary policy alongside looser fiscal policy has done “reasonably well” in keeping data stable in the US but “fiscal impulses don’t come for free”.
“We had a reasonably strong fiscal impulse after Covid and I think people forget that these act with a lag, in [the same] way that monetary policy acts with a lag,” said Sun-Wai.
One result is that debt to GDP is starting to rise, while budget deficits are high, particularly in places such as Europe – something she argued is not priced into markets.
“Whilst rate cuts seem efficiently priced, rate curves are still flat so we think there needs to be more term premium priced into the back end of curves,” she said.
Ben Lord, manager of the £1.3bn M&G Corporate Bond fund, agreed. He said policy rates “are still restrictive” and that central banks “are waiting too long to do something”, which means there is “lots of uncertainty all around”.
“To my mind, the expectation should be that the economic data slows a bit going forward and that usually means credit spreads probably end up widening a little bit from here,” he said.
As such, he is reducing the risk in his portfolio, which he co-manages with FE fundinfo Alpha Manager Richard Woolnough, moving up the quality curve and adding liquidity.
Indeed, if you take on more risk by selling an A-rated bond and picking up a BBB bond, “you are getting paid less than 40 basis points for doing that”, a mark that is “easily the tightest it has been in the past 10 years”.
It also implies that investors want to be short duration. Taking the example of a corporate bond yielding around 100 basis points above government bonds, if you divide this by a duration of five years, there is a breakeven rate of 20 basis points. This means if spreads widen by 21 basis points then investors have lost the additional yield on the bond and should therefore have owned a “govvie”.
“That doesn’t seem particularly generous, but it doesn’t seem bad,” said Lord. However, with a flat yield curve, a 30-year bond with a 100 basis point spread means the breakeven is just 5 basis points. “You can lose that in an afternoon,” he said.
“You haven’t got a lot in margin of safety. So we wait and hope that we get that opportunity to put some of the capital back into the market at a better valuation. That is very much how we are positioning in this market. Spreads are tight so we think it is appropriate to be patient,” he said.