So now we know – the waiting game is over and we’re working with a 50bps reduction in US interest rates. But no time to stop… our thoughts move on to the speed and trajectory of the cutting cycle that’s finally in motion.
Given as recently as April there was talk of the Federal Reserve’s (Fed) next move being a hike, there’s been a lot for markets to digest over the summer. But after front-loading with a jumbo 50bps, the Fed is projecting a cutting cycle in line with the historical average pace with a series of 25bps reductions.
The latest data shows the market has priced a further eight 25bps cuts, so 10 in total through to January 2026 – a level unheard of outside of a recessionary scenario. If US inflation does fall to trend and the economy is weaker – but still generally OK – then this is likely too many cuts over too short a period, and the market will need to adjust expectations with the incoming data.
That said, we are coming out of an extraordinary hiking cycle, where the economy was still struggling to shake off the effects of the Global Financial Crisis before Covid hit in 2020, meaning the starting point for interest rate hikes was unusually low. Ten cuts would only represent a partial unwind of the 21 hikes that we saw, and a terminal rate of 3.0%, close to current estimates of the neutral rate – so there is a path to get there, but it will not be smooth.
While we question current market forecasts, there remains a reasonable path to significant cuts without the US economy entering a recessionary environment. As such, we believe fixed income portfolios need to be at least neutral on duration (interest rate exposure) for two reasons:
- GDP and the labour market can turn over very quickly. Historically, the turn-down in the labour market – which manifests as an increase in unemployment – happens very rapidly, so you want downside protection in your portfolio in case things deteriorate faster than forecasters expect. And, given the challenging economic environment, forecasting error has been very high since Covid, so that should be factored in. August’s fast and sizable moves in duration provided a good reminder of the benefits of neutral exposure.
- Rate cuts carry the same time lag to impact as rate hikes. We are not going to see an immediate improvement in GDP and unemployment following the first cut. This data should continue to slow until the rate cuts work their way through the system, with the backstop of jumbo cuts if the Fed has moved too late and we fall off a cliff.
In terms of positioning, we see Europe’s economic environment as notably weaker to the US, with the US growing at 2% versus a flatline in Europe. As such, financial conditions are tighter, European fundamentals are weaker and the region’s exposure to China doesn’t help its outlook. Our view is negative on reported and forecast data. We remain in higher-quality investment grade names and selective single-name high yield stories.
On credit more broadly, given the robustness of the US economy, we don’t see the need to take excessive credit risk to get attractive all-in yields, and an ‘up in quality’ stance should protect against potential downside. Indeed, US-focused high coupon, high carry opportunities remain appealing. The buoyancy in US equity markets also supports US high yield, where spreads should remain around the current tight levels, providing we see no indication of recession.
The next few weeks has a lot in store for markets as we gain greater clarity on what the next phase of the cycle is going to look like – with focus on growth and labour market data. As ever, we believe flexible, go-anywhere strategies that can allocate dynamically across sectors and geographies are best placed to capitalise on moves and changes in sentiment across fixed income markets.
