Head - Fixed Income Strategy
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Weighed down by a combination of forces for now, US long-term rates could rise once more once a COVID vaccine emerges. We favor positioning for a steeper US yield curve.
• At the Jackson Hole Economic Symposium on August 27, US Federal Reserve Chairman Jerome Powell announced changes to the central bank’s monetary policy framework. During his speech, Powell focused specifically on the persistent undershoot of inflation from their 2.0% longer-run objective. The Fed will adopt flexible average inflation targeting that will average 2.0% over time. This implies a willingness for the Fed to allow inflation to run above 2.0%, without the need to tighten policy. Powell also expressed some modification to the Fed employment mandate, implying labor markets can improve, inflation can rise, and policy rates can remain low.
• With forward inflation expectations still below 2.0%, policy rates are likely to be on hold for some time. Eurodollar futures are not pricing in rate hikes until 2024, while Fed futures are also implying lower for longer. In our view, we would not expect the Fed to consider raising policy rates until the recovery is sustained, labor markets improve and inflation stabilizes at or above 2.0%.
• For now, long-term US rates will likely be contained by a slow economic recovery, large-scale asset purchases by central banks, possible re-emerging concerns over rising COVID infections and the delay of additional fiscal stimulus. However, a credible COVID vaccine could push 10-year yields back over 1.0%. We favor positioning for a steeper US Treasury curve, while taking advantage of low policy rates by using leverage to enhance portfolio yields.
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• With real rates negative, we prefer credit risk to interest rate risk. Spreads in corporate credit have narrowed meaningfully, supported by central bank asset purchases. The coming months do present some risks to markets (i.e., US election, COVID reacceleration), however, the Fed’s unprecedented credit facilities are expected to limit significant spread widening. We continue to favor high yield bonds (particularly Fallen Angels), preferred stocks, structure credit and emerging market debt