The Fed rate-cutting cycle offers several opportunities for investors, but how that cycle unfolds in the coming months remains an unknown. Several fixed income experts at Natixis Investment Managers recently weighed in on their outlooks on rate cuts and where to look for opportunities within bonds.
After a historic rate hiking cycle, the Federal Reserve kicked off the beginning of rate cuts with a 0.50% rate cut in September. Matt Eagan, Head of the Full Discretion Team and Portfolio Manager at Loomis, Sayles & Co., believes rate cuts will likely not be as substantial as in previous rate-cutting regimes.
“We think this is going to be a shallow rate cycle relative to history. During past disinflationary periods, it wasn’t uncommon to see 400 basis points or 500 basis points rate cuts,” Eagan noted. “This time, I think you have to curb your enthusiasm.”
In an environment of shallower rate cuts, Eagan sees opportunity for bond investors in the five-to-seven-year range within the curve. Eagan finds this slice of the curve particularly attractive for its potential to generate improved risk-adjusted returns for investors, with a tendency to hedge shorter in duration as opposed to longer.
Challenges and Opportunities for Bond Investors
For Adam Abbas, head of fixed income and portfolio manager at Harris|Oakmark, the key indicator to watch will be the labor market.
“The question for me is what the driver of rate declines and magnitude is,” Abbas queried. “I think Powell wanted to jump-start with 50 bps, and then it is going to depend on what the labor market looks like.”
Beyond the labor market, Abbas also sees structural challenges in the breakdown of global supply chains, rising deficits, and the lack of the government putting a floor on assets. Collectively, these challenges will lead to an elevated terminal rate of around 2.5% instead of the Fed’s desired 2%, according to Abbas.
In such an environment, bond investors would do well to consider credit, given the amount of cushion currently in the economy. “Never before have we gone into a recession at the beginning of a rate-cut cycle with this elevated of GDP,” Abbas explained.
See also: For Retirees, Interest Rates & Inflation Remain Risks
Looking Ahead to 2025 Rate Cuts
In the next six months, Peter Palfrey, Core Plus Bond Team and Portfolio Manager at Loomis, Sayles & Co., foresees substantial declines in inflation. By March, Palfrey believes Core PCE will be around 2.1% or 2.2%. When housing is removed from that calculation, core PCE would likely fall below the 2% target.
“I think that could get the Fed nervous because the Fed is very mindful of the fact that even in the forecast, we are expecting unemployment to go from the present 4.2% to 4.4% at the end of the year and drifting higher next year,” Palfrey explained.
Because of their focus on not just inflation but also the labor market, this could result in a “surprise to the upside” by the Fed. In short, bond investors should remain cautious and plan for a number of possible eventualities, as the rate-cutting cycle appears as unprecedented as the rate hikes over the last two years.
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