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Fixed income

The Fed is finished. What’s next?

Anders Persson
Chief Investment Officer, Head of Global Fixed Income
Tony A. Rodriguez
Head of Fixed Income Strategy, Nuveen
Taxable FI commentary

Key takeaways

We believe the U.S. Federal Reserve (Fed) is finished hiking interest rates, and attention should turn to the pace of rate cuts. Higher rates make fixed income more attractive, and building a diversified fixed income portfolio now helps position for an eventual rate decline. We advocate a multisector approach that takes selective risk in credit sectors. Active management remains critical, as credit spreads are likely to widen in the coming months.

Fed policy rates have plateaued, with cuts on the horizon

We believe the Fed is done hiking interest rates, and other central banks will likely follow suit. We currently anticipate 150 bps of rate cuts next year. We’ve penciled in six cuts in 2024, driven by two main dynamics:

Inflation should decelerate further. We think this will be the biggest factor driving the Fed cuts. The real interest rate equals the nominal rate minus the expected inflation rate. Therefore, real interest rates rise as inflation decreases, all other things equal. This increase in real rates slows the economy naturally without further policy intervention. As a result, the Fed will need to reduce rates just to keep the stance of its monetary policy steady. Our base case is for core inflation to end 2023 around 3.2% and end 2024 around 2.75%–3.00%.

Inflation has already eased substantially and is set to continue

We expect the European Central Bank to begin cutting rates early in 2024, with 50 bps by midyear and another 75 bps in the second half.

Economic growth will likely slow. We expect real U.S. gross domestic product (GDP) growth to decline from around a 3% annual rate in 2023 to 1% in 2024. The pace of job creation should continue slowing, exerting upward pressure on the unemployment rate. Government spending and net exports — tailwinds in 2023 — will likely revert to flat or slightly negative. Consumer spending should remain healthy, but slow somewhat. Fixed investment will likely be mixed, with a further slowdown in non-residential investment and a rebound in housing activity. With this slower growth and heightened downside risks, the Fed is likely to ease policy by even more than the decline in inflation.

In a bear case, such as an outright recession, we would anticipate substantially more rate cuts next year, likely closer to 200 bps. In a bull case, where inflation remains high and growth does not deteriorate, we would anticipate zero rate cuts in 2024.

Given our outlook for modest rate cuts to start next year, we expect the U.S. Treasury yield curve to move lower. We believe fair value for the 10-year Treasury yield in the medium term is around 3.50% (a real rate of 1.50% plus 2.00% inflation).

Interest rates are likely to moderate over the course of the year

Higher quality, non-Treasury sectors are attractive

We think a diversified multisector approach, with a focus on selected credit sectors, positions portfolios for the future market environment.

Despite the recent rally, yields remain very attractive. Over time, income has accounted for most of a bond’s return. Even though cash yields are attractive, other sectors may offer higher yields.

Adding sectors with longer duration positions portfolios for the next move in rates, which we believe may be lower. Potential rate declines may help create price appreciation in non-cash assets. We still think it makes sense to add duration risk at the margin, even after the recent rally in long-end rates.

Non-cash sectors offer both yield and duration

Active management is critical. Corporate market credit spreads have tightened to 18-month lows, boosting returns. While this slightly reduces the scope for future outperformance, overall starting yields remain attractive. Active managers use bottom-up fundamental credit analysis to sort through markets and help build sound portfolios. We favor taking selective risk in credit sectors, including investment grade and high yield corporates, emerging markets and senior loans.

Timing is never perfect

While the driving factors may appear simple, navigating changes in rates can be potentially more difficult than timing the stock market. The rates market tries to predict the path of inflation, economic growth and even the Fed. Anticipating these and other unknown factors, intermediate- to longer-term rates often decline suddenly, and long before Fed action seems imminent.

Extending a portfolio’s duration now can help capture the potential price appreciation created by additional rate declines. For the more cautious, we suggest using dollar cost averaging to enter the bond market over time.

Consider actively managed, diversified multisector portfolios

Now that the hike cycle is over, we advocate diversified multisector portfolios with longer duration profiles. As the economy begins to slow, the intensive, bottom-up fundamental credit research active managers employ can help avoid any problem situations. Broad diversification also reduces the impact of any single sector or industry on overall returns.

Consider these ideas for fixed income allocations:

Multisector bond funds. The additional yield potential can help build total return. The funds augment a base of diversified higher-quality sectors with larger allocations (typically up to 50%) to below investment grade securities. This approach offers more yield potential than core plus, in return for greater potential volatility.

Core plus funds. The ability to actively adjust allocations to lower-quality segments may increase yield while balancing overall risk. These funds combine a larger portion of higher-quality sectors — like U.S. Treasuries, mortgage-backed securities and investment grade corporates — with smaller allocations (typically up to 30%) to lower quality sectors, such as high yield corporates, senior loans and emerging markets debt.

Core/core impact with small amounts of plus sector exposure. These funds focus on higher-quality sectors to maintain return profiles similar to the broad bond market with a low correlation to equities. Core strategies with the flexibility to add small amounts (0% to 10%) of lower-quality sectors can be particularly attractive. Core strategies with an impact investing mandate add the diversification of responsible investing themes.

Outlook

The outlook for growth is expected to soften

We continue to expect growth to moderate to a below-trend pace. We see heightened risks of a recession in the U.S. and Europe in 2024, though the magnitude of a downturn should be mild by historical standards. Job growth, which has begun to decelerate, is likely to continue to moderate in the coming quarters. Inflation has likely peaked but will remain “too high” relative to central banks’ targets this year. Nevertheless, the policy focus is likely to shift away from too-high inflation and toward too-low growth.

We believe the Fed is done hiking rates and now anticipate 150 bps of rate cuts this year. The ECB has also finished its tightening cycle, and we expect a similar pivot toward cuts before mid-year. In China, policymakers will likely continue with their fiscal policy support, though substantial monetary easing is unlikely.

We continue to favor spread sectors and credit risk in asset allocation, with an upin-quality bias within asset classes. We believe credit spreads are likely to widen in the coming months, likely presenting more attractive entry points for risk taking. That said, we see attractive opportunities in the preferred market and in BB rated high yield and senior loans. We do not see much further upside for long-end yields.

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Endnotes

Sources

Inflation: U.S. Bureau of Labor Statistics Consumer Price Index for All Consumers. Employment: Bloomberg, L.P., Bureau of Labor Statistics, Nuveen. Global debt and yields: Bloomberg L.P

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Performance data shown represents past performance and does not predict or guarantee future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.

Important information on risk

Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk, and income risk. As interest rates rise, bond prices fall. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity, and differing legal and accounting standards. These risks are magnified in emerging markets. Preferred securities are subordinate to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Certain types of preferred, hybrid or debt securities with special loss absorption provisions, such as contingent capital securities (CoCos), may be or become so subordinated that they present risks equivalent to, or in some cases even greater than, the same company’s common stock. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. Non-investment-grade and unrated bonds with long maturities and durations carry heightened credit risk, liquidity risk, and potential for default.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

Nuveen, LLC provides investment solutions through its investment specialists.

This information does not constitute investment research as defined under MiFID.

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