Year of the Coupon Continues

Developed markets fixed income outlook

Global bonds have mean-reverted to a more historically normal environment (see Exhibit 1). The quick take is that income in fixed income is back to being a driver of performance.

Keeping the story simple in an increasingly complicated world, developed market bonds offer both income and value. However, it is U.S. Treasuries that have our attention as we believe they will provide leadership going forward.

During the second half of 2024, the time will be right to move out of cash and to position farther out on the Treasury curve, in our view. Since the next move by the Federal Reserve (Fed) will be to cut rates, some of that over $6 trillion in money market funds will become a source of funding for U.S. Treasuries (see Exhibit 2). Those funds likely are not going into equities given stretched valuations. The “unknowns” are the timing of Fed rate cuts and their magnitude. For now, the Fed thinks it will take a nuanced approach and nudge rates lower, more so in 2025 than 2024. History shows this is not the norm. Typically, there is a “crisis” in which something is breaking, and that becomes the reason for the Fed to cut more aggressively.

We like the return potential of longer-dated U.S. Treasuries. In line with our call that 2024 will be another year of the coupon in fixed income, Treasuries pay an attractive coupon, and unlike cash, time is on your side. Additionally, longer-dated Treasuries have a “kicker” of potential price appreciation when the Fed is forced to cut more aggressively.

So, what will drive the Fed to act more forcefully? If it comes down to only one economic data point, initial/continuing jobless claims in the U.S. would be the series that warrants watching. Recent claims data point to an acceleration in labor market deterioration, which confirms the increase in the unemployment rate that has been unfolding for months. The Fed has emphasized the labor market’s importance, even more than inflation, and remains sensitive to shifts in the jobs data.

One way to think of longer maturity bonds, i.e., 10- to 30-year, is as a low-cost insurance policy on something going wrong with the economy. In two out of three scenarios—the Fed on hold or the Fed cutting rates—U.S. Treasuries will offer positive returns. The one scenario in which they will not work is the fat-tail event, meaning an event that is not expected and seen as highly unlikely, of a strong rebound in economic growth and a recovery in inflation. That is the scenario where the next move by the Fed is to hike rates, but it is not our base case. It also would be painful for bonds. Another risk that would be painful for the bond market would be a sweep by either party in the upcoming U.S. election. Depending on the party, a sweep likely means either more spending or more tax cuts, which would not be good for developed market bonds and U.S. Treasuries in particular.

In the U.S., there are two high-level factors we must monitor in analyzing our bullish Treasury bond thesis.

1. The first factor is the more straightforward one. We will be monitoring the overall economic backdrop for developments in growth and inflation dynamics as well as market environment factors. These are some of the more important ones:
   • Demand for U.S. Treasuries: This dynamic has clearly shifted. Recent auctions of longer-maturity Treasuries have been met with stellar demand, marking a major shift in sentiment around the Treasury complex. It is not that supply is shrinking, but demand influenced by weaker economic fundamentals has a stronger influence than never-ending Treasury supply. Furthermore, there should be less competition from corporate bonds as supply is expected to slow in the second half of the year.
   • Peak immigration in the U.S.: Immigration declines under both a Biden or Trump administration will have a labor impact and may detract from growth in a meaningful way.
   • Falling inflation: Inflation continues to grind lower, evidenced by May CPI and PPI, and the sources of lower inflation are increasing (see Exhibit 3). The last major source of lower inflation will come from housing, which is a lagging indicator, but we will probably need weakness in the labor market as the catalyst. Lower oil and commodity prices also help, including by unwinding the frothy long positions from the speculative hedge fund community. Remember, inflation has come down sharply without a significant economic slowdown—yet. What happens if we get a slowdown? Inflation will melt lower. For now, the direction of inflation is more important than the level of inflation. Inflation expectations are still well anchored.

• Bifurcated economy: Lower income, non-asset owning consumers are feeling more stress relative to higher income, asset owners. The same is true in the corporate sector. Large companies versus small businesses exhibit the same bifurcation in performance in this economy. This divergence is not sustainable.
• Equity market warning signals: Underlying dynamics in the equity market are cautionary—a potential negative wealth impact. The underperformance of cyclical stocks could be a barometer for global economic growth. Be on the lookout for a divergence in stocks and bonds, which may signal a shift in the expected soft landing turning into a harder landing. Remember, on a number of levels bonds are undervalued relative to equities.
• Fiscal policy: Relative to 2023, the U.S. has likely reached the peak of fiscal accommodation. The U.S. federal government cannot stay on its current fiscal path without risking political instability. Interest costs will continue to crowd out necessary spending, e.g., defense.
   

2. The second factor is harder to quantity. It relates to election volatility and the “shades of gray influences” we could see in economic data and markets in the second half of 2024. Economic data might not give its normal signal to markets as it may be influenced by the election cycle. This certainly could be the case in the U.S., and it may have already started. The chart below highlights the rare instance when current conditions in the University of Michigan survey are below the expected consumer confidence reading (see Exhibit 4). Our take on this development is that this year’s election cycle, whether warranted or not, is already having an impact on the U.S. consumer and, by default, the corporate sector.