Martin Lefebvre
Hi everyone, I'm Martin Lefebvre, Chief investment officer and strategist at National Bank. Welcome and thank you for tuning into our NBI podcast series. Our focus today will be interest rates and opportunities and the fixed income markets and to do so our guest is none other than Ian Steeley, International CIO at JP Morgan. Mr. Steeley is managing director and head of global aggregate strategies within the global fixed income, currency and Commodities group. He's based in London and he's portfolio manager focusing on multi sector bond strategies.
And within the global aggregate team, you was previously responsible for the portfolio management of enhanced cash and short duration portfolios. Ian, welcome and thank you for being with us.
Iain Stealey
Great. Great to be here. Thank you so much for having me.
Martin Lefebvre
Excellent, Ian. Before we jump into you with the fixed income market has to offer at these levels, let's start by giving a little bit of context on the current economic environment. In previous podcasts, we've talked abundantly about the necessity for central banks to rein in inflation, but markets don't seem to agree with the end result will be with on the one hand, bond markets pricing in higher yields for longer, while on the other hand, credit markets seem to be trading sort of of the pause and soft landing scenario, which spreads still not indicative of a recession to come.
What's your take on the question? Is the Fed doing enough or too much? And what factors should be influencing the decisions from now on?
Iain Stealey
So I think the Fed has been on a bit of a journey over over the last 12 months or so from a position this time last year when they obviously weren't doing enough where they were behind the curve and they weren't reacting to the the price pressures that we saw out there. But they've obviously had a very strong influence over the markets over the last 12 months where they have been very aggressive and we've seen the fastest pace of rate tightening since since the early 80s and we've now got rates up to what you would perceive is a restrictive position, yet as you point out, it's not really slowing the economy yet to the the state that the Federal Reserve themselves would probably have hoped it it would be. Now we are very much aware that the rate hikes that go in the tightening and monetary policy has long and variable lags to the impact to the US economy.
And I think what's different maybe this time around is that we're still in that's sort of euphoric period of, of COVID reopening where we're still seeing a lot of activity. There's still a lot of pent up savings. There's still a lot of people that want to get out and do things that they hadn't been able to for such a long period of time. And those long and variable lags are just being longer than through previous cycles. So I do feel that the Federal Reserve has done a lot.
The market is still pricing them to do do a decent amount more we've got another almost 100 basis points priced in today, and I think they're gonna be wanting to see what the impact it has on the US economy, both from a inflation standpoint. So what's happening to prices, but also from a jobs standpoint, what's happening to the unemployment rate and and whether we are seeing whether it does finally move higher as so I believe they will be reacting for going forward to to the data, and I think they're in a position where they do feel they've done a lot, they feel they can do more, but they do want to see how the data plays out. So I think it would be more data dependent as to how they react going for further going forward. And I also think some of these may be oversized hikes that we saw last year, the 75 basis points, those I would hope are a thing of the past and we are more in a traditional rate hiking cycle of 25 basis points. Given how much has been done in such a short period of time.
Martin Lefebvre
So Powell was just talking in front of a Congress lately, and he sort of opened the door to a 50 bips increase. It's still a possibility. So what type of data would you see or would be needed in client and to do so?
Iain Stealey
So I think it's really 2 bits of data that we respect and see over the next week. And firstly we've got the jobs report that are non farm payroll reports this coming Friday are obviously we had a blockbuster report in January, much stronger than anyone, anyone, anyone forecasts. And I think that really started this movement higher in yields and the repricing that we saw in fixed income, fixed income markets. So I think that report's gonna be very key.
Was there's a lot of discussion about perhaps a milder period in January following quite a cold spell in the run up to the end of the year. And are there any seasonal impacts of that and how is this is the strong jobs data we saw in January, is that start of a new trend or was it more of a one off so very, very close attention to that this coming Friday and then we've got the inflation inflation report next week. So again that was the other sort of conundrum for the Federal Reserve.
Last month was that actually inflation didn't fall to the extent that they were hoping it to, both on the headline and on the core side. And I think there will be keeping an eye on that. The expectations are that both headline and core CPI year over year numbers moved down for the February report. But again obviously that's gonna be a key determinant. So I think those are the two key data points. And if they are both strong beats of expectations, if we see another, I don't think we're gonna see another 500,000 job gain in the US, but you know, if you see those sorts of numbers, if we see inflation move higher year over year, then yes, yeah. As Powell indicated today, maybe they will revert back to to 50 basis points.
Martin Lefebvre
Alright. Turning to Europe, you know in the midst of the uh, the war in Ukraine and energy prices jumping up, many people were expecting a severe recession in Europe in 2023. Now we see that gas prices have come down China's reopening and it seems everything is getting into in order.
What's the the ECB, the European central banks approach to monetary policy considering all of this uncertainty?
Iain Stealey
Yeah, I think Europe are very interesting environments at the moment and and you're right, we we had a period where I think the Bundesbank at some points last year we're talking about possible 5% GDP decline in Germany based on the increase in gas prices following what was going on in the Ukraine. But the reality is that Europe, through some of its own good work, they filled up the gas storage tanks but also through some period of good luck. We had a very mild winter in Europe meant that actually gas supplies weren't diminished or as to the extent that had that many expected. And actually the European economy seems to be bouncing back pretty nicely at the moment. And then the ECB have got an environment which is, you know, are you would argue from a pricing standpoint even more challenged than the US because we're not seeing core inflation falling yet.
So although the Federal Reserve will not be happy in the US, at core, inflation is still elevated. It is on a downward trajectory, albeit slowly, in the in the Europe, the eurozone, that's not the case. We're seeing core inflation continue to move higher and just in the way the basket of core inflation will be monitored over the next couple of months, that is likely to continue. So you've got a European Central Bank that was even slower to the rate hiking party than the Federal Reserve was. They only started last summer and they're still kind of behind in magnitude of of rate hikes relative to a number of other central banks in, in the world. So it feels like they still got a lot to do and and we had the Austrian ECB Council member yesterday coming out saying that they could see four more, 50 basis points hikes. Now that's at the hawkish end of maybe expectations. But I think that shows you some of the work the European Central Bank still still needs to do and are our base case at the moment is that we will see more hikes from the European Central Bank this year, then, we're likely to see from the Federal Reserve.
Martin Lefebvre
Yeah. And if they do so, that will certainly help the euro regain a little bit of strength on the way forward. Are there any other major central banks that we should be focusing on when it comes to monetary policy? I mean we we look at the fare, we look at the ECB, we're starting to look a little bit more about the Bank of Japan. But are there any, you know, major central banks that do have an impact and should be followed?
Iain Stealey
I think you hit the nail on the head there. I think it's the Bank of Japan, which is a really interesting central bank. Obviously when you look around around the world and you know there, there, there has been paces of magnitudes of central bank tightening, but the one outlier out there remains the Bank of Japan who are still in negative interest rate territory and have still got yield curve control in place. So they're still effectively supporting their the bond markets through through purchases at the same time as we're seeing quantitative tightening from a number of other central banks around the world now, Japan's inflation outlook hasn't been there as, say, the US or Europe, but it it is definitely moving higher and it is definitely moving to levels that doesn't warrant 0 interest rate policy or negative interest rate policy and yield curve control. And it's now I think just a you know a sort of a matter of when, not if they start to or they continue to remove the the bands that have been put in place and then start to look at normalizing policy and what we what we've seen over the last few months is they they they want to. They seem to want to surprise the market. So they the last yield curve control band Move was in December when the market wasn't expecting it.
There was then a view that they could do more in January, but they didn't. We've got a meeting coming up this coming Friday. I think the market expectations they will not, they will not touch it, but there's always a risk and we're also seeing a shift in leadership in Japan. So Corona is is taking or ending his tenure as the Governor of Japan and he's handing over to Ueda and will this be a period where actually they can shift the way they think about monetary policy and that will have a big influence on global fixed income markets because it's still the big component of global fixed income markets where yields still look too low relative relative to policy. So I think that's the major central bank at least I'm focusing on over the next couple of months or so. And I say it could even be as early as this Friday when things get interesting.
Martin Lefebvre
And the current pace of purchases certainly seemed unsustainable. So we'll be interesting to watch that indeed, OK, so let's now pivot to what it means for fixed income markets. Can you tell us how our interest rates are affecting the demand for fixed income securities right now? And what implication does this have on investors?
Iain Stealey
So we, we've seen a huge repricing in the bond markets over the course of of 2022. We went from 1 1/2% on a 10 year U.S. Treasury. We're up hovering around 4% at the moment. And I think how we're looking at it is that this is becoming a very interesting market for investors. There are a number of people out there that I talked to that just haven't been interested in fixed income or in bonds for the last decade or so. And suddenly we're getting levels where actually that you could argue value is back. If you look at at core government bonds on a real yield basis. So the additional yield that you get owning a core bond taking into account what the market perceives inflation to be over over the next over the life of that bond then actually the yields you're talking somewhere in the region of 1 to 1 1/2% for it for a number of core global government markets.
And those yields are the most attractive they've been since the global financial crisis.
Martin Lefebvre
Well, there, there were negative nuts so long ago, right?
Iain Stealey
They were. They were deeply negative not so long ago. They're now positive. If you look at the, you know, US tips so inflation links, treasury inflation, protected securities and use, you can get a real yield on the 10 year part of the curve of around 1 1/2%. They were -, 1% not that long ago. So there's been a huge repricing and that's bringing people back into the bond market. People who haven't owned bonds for a long period of time, people who haven't seen fixed income as a diversifier again, we obviously had that positive correlation between equities and bonds last year, which does not help for a multi asset or a balanced portfolio.
So we are definitely seeing a huge amount of demand and that's you know, we're not not saying sitting here saying that that you know, we've definitely hit seen the highs in in yields. But given the repricing given the valuation that's being created, there's a lot of interest in in fixed income markets.
Martin Lefebvre
Yeah, I do. I do agree with you. When you know the 25 bips increase from these levels is doesn't have as much impact as starting from a very low yield of 1.5%. So there is indeed a little bit more potential and holding the asset class and that's why the the 6040 split seems to be more invogue especially with the equity risk premium being that almost historical lows as we as we speak.
What about duration? What kind of role does it play and what type of direction would you be inclined to to go on right now or you over? Are you above duration or neutral or what? What kind of stuff do you?
Iain Stealey
So at the moment we've got a more neutral stance on duration. We were we spent most of last year deeply underweight duration, at least relative to where we position the portfolios historically, taking advantage of what we thought was going to be a movement higher in yields and we think we're in a spot now where I say bonds at least are fair value.
And I think from our standpoint, what we will be looking to do is as we continue to see yields move higher, we will be looking to accumulate more bombs. And what I would like to to definitely see as as I mentioned earlier, it would be great to possibly see some of those inflation levels tick down. Again, not such a strong jobs market in the US to have maybe more conviction that what is priced into the Federal Reserve from a tightening standpoint is likely to be the peak and we are likely to see the Federal Reserve pause, but I think you know the reality is that we are at levels now where you are, you are compensated to buy to buy fixed income and you know as as you mentioned we are unlikely to see the scale of moves that we saw last year and you're sitting on a pretty pretty nice yield cushion to start with. Again that was not something that was available at the start of of last year. And I think the the big benefit from having duration at the moment and it goes back to your point on, say, A 66040 mandate is bonds can now act as that diversifier if we do start to see a slowdown in in the global in the global economy. And we do start to see central banks or we see a period where central banks are going to have to ease to support support that you know when you're at 1 1/2% on the 10 year Treasury, it's quite difficult to see a significant move lower and yields.
When you're at 4%, you know yields could easily be 3 or 2 1/2%. If we start to think the Federal Reserve will have to go on a meaningful cutting cycle to support the economy and then you're gonna be able to gain a really attractive capital gain on the back of the yield that's on offer. So in that environment, you would, you would expect fixed income to do what it's supposed to do, which is to provide that ballast and diversification to a portfolio of multi assets.
Martin Lefebvre
Perfect. What kind of challenges do you see investors facing and the fixed income market and there are there any steps that they could take to address them?
Iain Stealey
So I think the the main challenge that we're seeing at at the moment is just how how strong the credit markets are. So if I look at the high yield space today, we've seen spreads tighten over the course of this year and tighten significantly since they the wipes that we hit during last summer and we're now back to, I believe a market that is pricing in that Goldilocks soft landing scenario.
If you look at high yield markets today, I've got the US with the spread of around about 400 basis points now the long run average over the last 20 years or so is is north of 5%. So we're well through long run averages and actually when you look back over the last few years, really the you know we've we're off the tight we saw tights of 330 basis points or so. But remember that was an that was an in a period of 0 interest rate policy quantitative easing $15 trillion worth of negativity yielding bonds. There wasn't really an alternative. You had to stretch for yield to into the high yield space to be able to actually achieve the yield you'd want from your fixed income portfolios. And I don't think that's the case anymore. I think you can actually get a well diversified global fixed income mandate, a very high quality bonds for pretty attractive yields today. So I do think there credit markets, particularly lower quality credit markets, can be a little bit challenged. I don't really see the spreads going much tighter from here. So it's really carry you'd be giving up. So I would prefer at the moment there how do we address this concern? Well, actually it's to go up in quality. So it's to look at some of the higher quality parts of the fixed income space. So we do think corporate health is still remains pretty good and we think you can get pretty attractive yields being in in high quality fixed income. Just put it in context, if you think about where?
Yeah. the US high yield market was at the beginning of 2022. Well, you were talking, you know, yields of four to 4 1/2%. Yeah, you can get higher yields than that and meaningfully higher than that, owning high quality investment grade credits today just given the repricing that we've seen in the risk free rate. So I think it's, it's a world where going up in quality makes sense and and then hopefully we do see the way we positioned the portfolios. We do see a little bit of spread spread widening and that will then allow us to to reinvest in in that part of the market when we believe the valuations compensate you front for the risk.
Martin Lefebvre
What kind of spreads are you looking after and perhaps in conclusion, what what are you buying right now? What's your team's best ideas?
Iain Stealey
I think that's that's a great question spreads because if you go back through time and through history, you would say that high yield spreads should be somewhere in the 800 to 1000 basis points for for a recession. I think the reality is that actually corporate health is better than really probably any period in the run up to a slowdown and that we can remember over the last couple of decades or so. And we have seen an improvement in overall credit quality of the market, if you think through you know the composition of of the US high yield market, you know the the double beat components that the highest highest credit quality part of that market has gone from 40% to 50%. We've had the triple C component, the lowest credit quality go from 18 down to 11%. So it's definitely a better mix of securities there. So I don't think we're gonna see spreads as wide as you would have had through a historical recessionary environment.
Yeah. If we're at 400 basis points today, I would expect if you're moving towards 6 hundred, 650 base points, you want to start accumulating bonds. And again, you're never gonna hit the absolute wide and spreads because the reality is you're probably the market only be there for a very short period of time. So I think that's probably a pretty attractive place to start allocating. What are we doing at the moment? As I said, we are going up in quality, we're looking at high quality investment grade corporates that we're very comfortable with. We actually like some of the local emerging market bonds out there today where we've seen central banks be very aggressive in tightening policy. They were they were tightening policy back in 2021 before the developed markets were central, banks were participating in that. And we feel that they've got to a stage where you can get some very attractive real yields on emerging markets. So that's another area that we like. And then just generally say we do believe that this is environment when you want to be adding fixed income back to portfolio. So if we do see yields rise a bit further from here.I think it's generally adding duration to portfolios if that makes sense.
Martin Lefebvre
Iain, this was very interesting. Thank you very much once again for being with us. Everyone. Thank you for tuning into our NBI podcast. We'll talk again next month.
Iain Stealey
Thank you.
Martin Lefebvre
