Mabrouk Chetouane and Philippe Berthelot discuss central bank policy, inflation, and the importance of duration management in fixed income investments
Mabrouk Chetouane: If I look at what has happened since June, when Christine Lagarde announced the ECB’s first rate cut since 2019, the bond market still appears to be being led by the US, despite the rate cut. Do you think we are going to have to wait for more clarifications from the ECB before we will be able to see if the European bond market performs independently from the US bond market.
Phillipe Berthelot: I agree that the US fixed income market is a leader when it comes to rate movements. What is clear is that inflation has been trending down and that has been good news for fixed income performance. And we believe it is likely to continue, albeit in not quite as dramatic a fashion as some in the market believe. If you looked at the shape of the yield curve earlier this year it was amazing. It was inverted, largely because the market was expecting so many rate cuts – a few too many in my opinion. From what we have heard from the US Fed chair, Jay Powell, the somewhat more moderate path indicated, is, I think, a good one, and one that is increasingly being priced into markets. We expect two further rate cuts at the Fed level and at the ECB level.
MB: We also expect to see two rate cuts both for the ECB and for the Fed in 2024, which is, I think on the more cautious end of market expectations. Many people are still expecting three, maybe four, and we all know that this could be a source of disappointment – and volatility – for bond investors. But, if we look further out into next year we do expect further cuts and this is, as Philippe said, a very supportive trend for bond market. Four rate cuts is the central scenario of the Federal Open Markets Committee (FOMC) and this is, I think, aligned with the expectation of six cuts in total, two this year and four next year, which would mean rates reaching 4% by the end of next year. This figure corresponds exactly to our projections in terms of growth and inflation. We expect inflation to reach 2.5% on average next year and growth to hit 1.5%, which is slightly below the potential and completely justifies those rate cuts. What is your outlook for next year?
PB: This is where perhaps we differentiate a bit. We do agree that the pace of a rate cuts expected by the markets was too exaggerated on a year to date basis, but for 2025 there is still the big question mark because central bank decisions will be made based on a combination of an employment figures, input prices and economic activity and that seems to have decelerated a bit more than we were expecting some three months ago.
MC: I agree that there are still a huge number of job vacancies in the US which is disturbing the matching process between supply and demand, which in turn supports some wage growth. We do not expect to see a dramatic increase in the rate of wage growth but the current level is sufficient, I think, to maintain the second round effect in the core inflation, and this is why we think the 2% target inflation level will not be breached in the near term. And this should result in a continuation of the elevated rates we have seen in the previous monetary policy easing cycles.
But, I also think it is important to recognise that the pattern of the rate cuts is unlikely to be the same as what we saw during previous monetary policy easing cycles. Inflation is likely to be far more persistent than it has been in the past. We don’t think it will skyrocket in the future, nor do we think it will plummet, but it will stay much higher than in recent years and this will constrain the speed with which central banks can make monetary policy adjustments. It is not higher forever, of course, but it is likely to be higher-for-longer and this will certainly modify the profile of the bond market returns and yield returns in the near term. Would you agree, Philippe?
PB: I would discriminate between rate volatility, spread volatility and equity volatility. Rate volatility is still abnormally high, we believe, despite the fact that everybody was expecting central bank rate cuts. The rate market is very nervous about the last publication of the CPI figure and the market has a propensity to overreact, which has been the case in the rate market.
Spread volatility, on the other hand has been far more muted. Spread products, have almost ignored what has happened in the rate market because credit performance has been so strong in the past two years or so. And it remains the case for the time being.
I would cite equity volatility too because spread products are very sensitive to moves in equity volatility, mostly the Xover CDS index, - when equity volatility goes up spreads tend to go wider, and vice versa.
MC: What does this mean for bond investors?
PB: People have been focusing on the short end of the curve for good reasons – short term rates are understandably appealing at current levels, but they won’t stay high forever, especially if we are seeing the start of a cutting cycle. That is why at some point, extending duration makes sense. Even if, on a spot basis, your two-year or five-year bonds have got a lower yield than what you can extract on the very short end, the added duration means there is the opportunity for further performance over the longer term. After all, in a rate cutting environment, duration serves as a multiplier for your expected capital gains. Even though the longer maturities may not look quite as appealing, at first glance, because of what you can get from money market funds today, we know that money market performance will go lower and lower in the near future, thanks to the central bank rate cuts. That is why I keep repeating the same phrase – riding the yield curve – because in this environment it is crucial to be flexible and nimble.
MC: I wouldn’t write money markets off completely, however. I think there is still performance to be found there, because I don’t think rates will fall immediately. But, perhaps more importantly, I think they will adjust gradually. In fact, I think this transition between the money market to the bond market and to the credit market could be quite smooth, because I don’t expect to see brutal changes to monetary policy either in Europe or the US. I think the idea is to adjust the level of interest rates such that they support growth without triggering additional pressure on the price front.
PB: Yes. I would agree with that.
MC: Perhaps as a final question then. If that is the view, how would you embody that from a portfolio management perspective?
PB: Well, I think the simpler way would be to reiterate what I said earlier. If you are in a rate cut environment, there is a propensity to extend duration, because extending duration offers either the benefit of still appealing yields or the potential for extra capital gains to come in a plain-vanilla fixed income portfolio. But, to your earlier point, timing will be critical.
