Rick Patel
Since the recent market volatility, there has been concern that US Treasuries have not been acting as a hedge for equities. Whilst the intraday volatility in rates has been severe, it is important to add some context and perspective to these moves.
Although Treasury yields have been volatile, overall moves have been more contained. At the end of April, the US 10-year is ~10bps higher than at the beginning of April, which is still ~50bps lower than YTD highs in January. Similarly, 30-year yields have moved sharply and are ~20bps higher MTD but flat on a YTD basis. In recent history, the US has relied on foreign investors to fund its twin deficits, but with the US at the centre of a tariff volatility storm, global investors are demanding more compensation to invest in Treasuries because of heightened uncertainty and increased potential for a US slowdown.
Ultimately the extent of the slowdown ahead will be a function of how US corporates respond to tariffs and whether they choose to absorb impacts in reduced profit margins or pass on price increases. Many S&P 500 corporates are currently announcing earnings, and this will provide some insight into how firms are navigating the impact, which will help to shed light on the magnitude of the slowdown ahead.
On the trajectory of the US labour market, much of the strength in 2024 came from healthcare and government sectors. Interestingly on the former, recent temporary employment leading indicators have pointed to a steady decline, with the demand for nurses falling on a year-on-year basis for the first time in a while. The government sector also continues to undergo its own challenges which should weigh on payroll numbers going forward.
In our view, the bottom line is that the Fed Funds rate of 4.25% is too high relative to expectations of limited structural growth and inflation rates going forward. The Fed appears reluctant to cut rates based on their recent commentary and are likely to require a catalyst to do so. A deterioration in the labour market might be a catalyst as they look to protect the maximum employment side of their dual mandate.
From a downside risk scenario perspective, if there is a recession with immediate job losses, the Federal Reserve will have to cut far more aggressively than the market is expecting. To put this into context, in this scenario, multiple 25bps cuts over subsequent meetings would do very little to support the US real economy, given that this cycle is unique due to the delayed nature of monetary policy transmission. For instance, around 75% of US households have a fixed-rate mortgage below 5% as many refinanced during the pandemic era of low rates, which is materially lower than the current market mortgage rates. Rates for smaller business are also punitively high, which is significant given that they employ over 50% of American workers. Clearly the market is not currently pricing in this scenario, despite it being a potential a tail risk. In the event this scenario does materialise, we would expect a Fed Funds rate below 2% as this would be their only viable pathway to provide support to the real economy.
There are many unknowns ahead and volatility is likely to persist as the situation around tariffs remains fluid and ever evolving. What we can say with confidence is that in response to this challenging market context, an active and nimble approach to investing is more important than ever. Maintaining a yield buffer through this environment is also key whilst remaining defensive, and one way to do so is through short-dated bonds with attractive yields rather than remaining completely on the sidelines in cash.
Clearly volatility and uncertain times are difficult from many different perspectives. However, our investment approach suits periods of volatility, and we believe there are opportunities ahead to deliver alpha and build on the strong relative performance achieved year-to-date and post ‘Liberation Day’.”
By Rick Patel, portfolio manager
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