Quick Thoughts: Preparing for a pause

There is a disconnect between the Fed’s message regarding taking a pause in hiking interest rates this year and the market’s expectations of rate cuts. Stephen Dover, Head of Franklin Templeton Institute, shares the views of the company’s investment leaders regarding the likely path for interest rates as well as how investors can best position themselves in this uncertain environment.   

There is a wide disconnect between the Federal Reserve’s (Fed’s) message and what the futures market is pricing in for the likely path of interest rates. How will the gap be narrowed? How should investors position around these potential scenarios? I looked for answers on both the drivers and impact of the future path of interest rates on fixed income markets in a conversation with Mark Lindbloom, Portfolio Manager, Western Asset Management; Rick Klein, Head of Multisector and Quantitative Strategies, Franklin Templeton Fixed Income; and Bill Zox, High Yield Portfolio Manager, Brandywine Global. Below are my key takeaways from the discussion:

• The market and the Fed have differing views on when rates will be cut. The futures market expects rates to decline rapidly starting in June, with 50 basis points (bps) of cuts in 2023 and 150 bps of cuts in 2024, to reach 3.25% by the end of 2024.¹ The Fed has said it will not cut rates in 2023, and the dot plots imply that rates will peak at 5.25% and fade to 4.25% by the end of 2024. 
• Our panelists believe that after the Fed’s last rate hike of 25 bps in May to 5.25%, it will pause any rate changes through 2023, and begin to cut in 2024.
• Current interest-rate spreads across fixed income markets imply that either inflation drops quickly, or the Fed eases quickly in response to a “hard landing.”
• Volatility was at record levels in the first quarter and will likely remain elevated. This will create opportunities for active managers.
• Our portfolio managers suggest a focus on quality, a slight shortening of duration, and a tilt toward investment-grade credit.
• Within this quality theme, opportunities are also presenting themselves in mortgage-backed securities, long-duration municipal bonds and short-duration high-yield bonds.
• High-yield debt can be used as a replacement for equity exposure, as the added protection of higher-starting yields in a slowing economic environment offers a better risk/reward profile. 

Achieving optimal portfolio allocations in the current environment requires remaining nimble and tactical, given the wide range of potential economic outcomes. The uncertainty is providing opportunities to capture yields and spreads across the fixed income markets at what we consider attractive valuations.