Fixed income outlook: harnessing a higher for longer conviction

Investors searching for clues about the likely direction of interest rates could be forgiven for scratching their heads. Falling inflation and signs that the economic outlook may not be as bad as feared had fuelled hopes major central banks – foremost the US Federal Reserve – may soon begin to pivot away from a path of higher interest rates they have pursued since 2022. In response, markets rallied across the opening weeks of 2023. But the release of the latest US jobs data showed employers hired more workers than expected in January. Bonds sold off as investors shifted gears – believing the latest data suggested the US economy may be running too hot and that the Fed would have to stay the course with policy tightening.

In our view, investors may now be coming around to our belief that central banks will likely have to keep interest rates elevated to tackle sticky core inflation. In short, interest rates may have to stay higher for longer. We think this belief is reinforced by the latest messaging from the Fed and the European Central Bank. Fed chair Jay Powell and ECB president Christine Lagarde have both reaffirmed their central bank’s willingness to keep rates high to ensure a sustainable decline in inflation towards its price stability objective. 

Going forward, we expect central banks will be hard-pressed to shake off any market perception of their role as “bond market-makers” or “fiscal-policy underwriters” of last resort. As expectations around liquidity and fiscal dominance come to an end, expect bouts of market volatility. 

Shifting economic growth outlooks may compound uncertainties in a complex market environment. Our proprietary leading indicators forecast that global growth continues to run below its trend rate over the coming months. We expect recessions in the US and Europe, given headwinds from tightening financial conditions and the squeeze in household real incomes, although the slowdowns may be milder than previously anticipated.

Focus on quality and beware of volatility

Measures of implied and realized bond volatility have eased from their recent highs last year. But the shifting macro outlook means there might be further instability. In this environment, it may be wise to avoid taking too much outright, one-directional risk in portfolios in the near term. Ideas to think about in the near future:

Fundamentals are a lot better than heading into previous periods of economic slowdown, but there’s still uncertainty over terminal policy rates and the fallout for growth. Our outlook continues to favor defensive positioning in fixed income with plenty of room ahead to add risk gradually through higher-quality debt sold by higher-quality issuers.