Fed rate cuts on the way: Fund managers’ view

The speech at Jackson Hole by Jerome Powell, chair of the US Federal Reserve, has made 18 September the date that news reporters, economists, and bond investors alike are most eagerly anticipated in years, as the central bank appears to be firmly committed to interest rate cuts at the next FOMC meeting.

Apart from watching the trend of the once-stubbornly high inflation rate, the Fed has most recently stated that the domestic jobless rate is also on the radar. Markets are watching how the jobless rate will impact the Fed’s decision on how much of a rate cut we are expecting in September and the pace of adjustments thereafter. 

In light of this, we had in-depth interviews with six fixed income managers and one multi-asset manager on the Endowus Fund Smart platform. 

Managers from AllianceBernstein, Invesco, M&G, Neuberger Berman, PineBridge Investments, Thornburg Investment Management, and Wellington Management spoke to Endowus prior to the September FOMC meeting in a two-part series. 

Soft, hard, or no landing? Managers’ base case scenarios

The consensus base case scenario fixed income managers have is a soft landing in the US. Estimates from Gershon Distenfeld, Director—Income Strategies and Fahd Malik, Portfolio Manager—Income Strategies at AllianceBernstein are that the below-trend growth over the next 12-18 months will support continued deceleration in inflation. “While corporate balance sheets are starting to weaken, they are still in very good shape, characterised by strong interest coverage ratios and low leverage.”

In addition, a recession or a hard landing is not in their base case scenario, but is regarded as “a risk to the forecast.” Recession could be triggered by geopolitical events or the “higher-for-longer” regime having a larger impact than currently anticipated, thinks the team behind the AllianceBernstein American Income Fund. 

Tobias Bracey, Client Portfolio Manager at Neuberger Berman, echoes the view and thinks that the trajectory of the US economy will be one of an overall soft landing, with GDP growth of less than 2% and moderating inflation. 

What are managers worrying about “recession”?

Even if it turned out to be a hard landing, a recession, defined as two consecutive quarters of negative GDP growth, is not so much as concerned about by Christopher Hamilton, Head of Client Solutions, Asia Pacific ex Japan, Invesco. 

“What we are really worried about is the rate of change in growth and deceleration. That is why we went into more of a defensive mode. You can go into that mode and not actually experience a true recession. It's happened before,” says Hamilton, who manages multi-asset investments for Invesco.

Invesco’s base case is somewhere in between a soft landing and a light recession in the US, the latter of which is the risk most concerned about. 

To him, the real risk is that the Fed gets “way out in front and cutting rates aggressively, and then seeing a re-acceleration of inflation, where they then have to stop the rate cutting or increase rates again.” According to Hamilton, this would trigger “a 2022 situation all over again,” when stocks and bonds both crashed. While the probability of that is low, that is the tail scenario we are most worried about, as opposed to a very cataclysmic recession.

Andy Suen, Managing Director, Co-Head of Asia Fixed Income, PineBridge Investments is mindful that every recession starts looking like a soft landing first. “The base case scenario is a soft landing scenario. We don't rule out the possibility of a recession.”

Unemployment rate in focus: What is in the data?

Despite the soft landing expectation among managers, high borrowing rates seep into businesses and the tick-up in the unemployment rate proves to be worrisome to most. The job scare triggered concerns about the outlook of the US economy in early August, leading to a short-lived selldown in US equities. This is coupled with other widely-followed gauges pointing to a looming recession. 

The most recent print of the unemployment rate improved slightly to 4.2% from July’s 4.3%. This not only breaks a four-month streak of increasing unemployment rates – anything below 5% is seen as a positive reading.

The base case for the US economy from Wellington Management is a soft landing, but the health of labour markets is under close watch. Campe Goodman, Fixed Income Portfolio Manager at Wellington Management says: “At this stage, we have taken the view that labour market softness so far is just an unwind of extremely tight labour market conditions and not a sign that layoffs are picking up significantly and potentially a more dire outcome for the economy.”

The concern for Lon Erickson, Portfolio Manager and Managing Director at Thornburg Investment Management, is, however, the delta. 

“While US GDP growth remains notably positive and consumer spending remains solid, the unemployment rate remains relatively low historically at 4.3%, but it has gone up almost a percentage point over the last 18 months.”

He continues: “History has shown that once unemployment starts trending upward, it is difficult to reverse. And, while the consumer has been resilient in the face of inflationary pressures, delinquencies in areas like credit cards and auto loans have increased markedly.”

In the less likely scenario of a recession (or hard landing), the expectation would be that long-term rates may fall, while short-term yields would likely fall more as the Fed would take more decisive and rapid action, according to Thornburg. 

Riding the cycle: What’s the Fed going to do?

Distenfeld and Malik from AllianceBernstein expect a slow pace of cuts to bring modestly falling yields. “We are a bit less dovish as our expectation is that the Fed is likely cutting 25 basis points at every meeting this year and into the next year. The pace of cuts is expected to slow as we move through 2025 (for a total of three cuts in 2024 and five cuts in 2025).”

Given that this is aligned with the market expectations, a big move in Treasury yields is not expected. That said, rate cuts are supportive of falling yields, and the forecasts from AllianceBernstein call for modestly falling yields. Specifically, their forecast for yields on 10-year Treasury bills for the end of this and next year is 3.75%, sitting at the midpoint of a 3.5% to 4.0% range.

Neuberger Berman believes that inflation continues to normalise towards the Fed’s target over the medium term, which is driven by shelter inflation normalisation. Bracey of Neuberger Berman anticipates three rate cuts of 25 basis points this year starting in September. 

The economy is unlikely to head back to another era of zero interest rates that lasted more than a decade. “The Fed rate is expected to fall to 4.50 - 4.75% by the end of 2024. This should ultimately settle the neutral rate at around 3.50%. However, the likelihood of the Fed reaching the neutral rate faster has increased.” 

Emerging markets may follow suit to reduce interest rates

Claudia Calich, the fund manager at M&G overseeing the Emerging Markets Bond Fund, holds the belief that if the US achieves a soft landing and sees interest rates fall, it will provide a favourable environment for emerging market fixed income as a whole. 

According to her, “From a rates perspective, it gives room for EM countries to continue cutting, or start cutting, themselves as they would want to wait for the US to cut first to maintain a buffer in rates. 

She further explains, “With US rates and local rates set to fall, we would see borrowing costs decrease for sovereigns as well as credits. With fundamentals being as strong as they are, EM corporates have been resilient to higher rates for the past couple of years but would welcome the step-down.”

Exploring fixed income funds on Endowus Fund Smart

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