There is a wide disconnect between the Federal Reserve’s (Fed’s) message and what the futures market is pricing in for the likely path of interest rates. How will the gap be narrowed? How should investors position around these potential scenarios? I looked for answers on both the drivers and impact of the future path of interest rates on fixed income markets in a conversation with Mark Lindbloom, Portfolio Manager, Western Asset Management; Rick Klein, Head of Multisector and Quantitative Strategies, Franklin Templeton Fixed Income; and Bill Zox, High Yield Portfolio Manager, Brandywine Global. Below are my key takeaways from the discussion:
- The market and the Fed have differing views on when rates will be cut. The futures market expects rates to decline rapidly starting in June, with 50 basis points (bps) of cuts in 2023 and 150 bps of cuts in 2024, to reach 3.25% by the end of 2024.1 The Fed has said it will not cut rates in 2023, and the dot plots imply that rates will peak at 5.25% and fade to 4.25% by the end of 2024.
- Our panelists believe that after the Fed’s last rate hike of 25 bps in May to 5.25%, it will pause any rate changes through 2023, and begin to cut in 2024.
- Current interest-rate spreads across fixed income markets imply that either inflation drops quickly, or the Fed eases quickly in response to a “hard landing.”
- Volatility was at record levels in the first quarter and will likely remain elevated. This will create opportunities for active managers.
- Our portfolio managers suggest a focus on quality, a slight shortening of duration, and a tilt toward investment-grade credit.
- Within this quality theme, opportunities are also presenting themselves in mortgage-backed securities, long-duration municipal bonds and short-duration high-yield bonds.
- High-yield debt can be used as a replacement for equity exposure, as the added protection of higher-starting yields in a slowing economic environment offers a better risk/reward profile.
Achieving optimal portfolio allocations in the current environment requires remaining nimble and tactical, given the wide range of potential economic outcomes. The uncertainty is providing opportunities to capture yields and spreads across the fixed income markets at what we consider attractive valuations.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested.
Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.
Bond prices generally move in the opposite direction of interest rates. Investments in lower-rated bonds include higher risk of default and loss of principal. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. High yields reflect the higher credit risk associated with these lower-rated securities and, in some cases, the lower market prices for these instruments.
IMPORTANT LEGAL INFORMATION
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.
Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.
CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.
__________
1. Source: CME Group, with analysis by the Franklin Templeton Institute.
