Flexibility, the recipe for dealing with the uncertainty surrounding the Fed

July 2024 by Ana Carrisso

How life can change in six months! At the beginning of 2024, our base scenario assigned a 60% probability to a cyclical recession. In the revision of our macro outlook for the second quarter, our experts reduced this probability to 20%, and now the central scenario we work with at Fidelity is that of a soft landing, with a probability of 40%. The truth is that, over the last few months, the markets have done nothing but try to adapt as quickly as possible to the different messages that the Federal Reserve has been sending out: if 2024 began with the expectation of up to six interest rate cuts, now the consensus is for no more than one cut for the rest of the year. 

We were not unaware of the possibility of such a revision of forecasts. We're working on the assumption that the Fed won't touch the price of money until at least the fourth quarter of the year. It may not even cut rates this year. And when it does, we think it will return to the mantra of recent times: any future monetary decision will depend on the evolution of macro data. 

The US elections

This turnaround in market expectations once again reflects the Fed's lack of consistency in its communication on inflation. Let us remember that in 2021 it stated that the increase in inflation was temporary. It had no choice but to rectify this statement in 2022, with one of the most aggressive monetary tightening cycles in history. In the last quarter of 2023, it launched the idea of a soft landing and gradual disinflation, only to change its tune again in January when it realized that inflation was not falling towards its target as quickly as it had predicted. And so we arrived at the point where we are now: a context of higher interest rates for longer, justified by the continued strength of the North American economy and the persistence of inflation. 

A third element must be added to this context: the US presidential elections. We believe this macroeconomic cocktail could maintain the gradual upward trend in US Treasury bond yields that we have seen since January, or at least remain in a narrow channel. It would be foolish to ignore the risks that these elections entail for the US economy (high and growing budget deficits, pressure on household spending, ballooning debt), so we believe that maintaining an overweighting in the probability in the duration of US rates in the medium term is justified. 

The ECB and the divergence with the Fed

In Europe, on the other hand, a slightly different line is expected. The ECB's communication has been clearer about its intention to start cutting interest rates in June. Its implementation will lead to a divergence with the Fed, which investors will have to deal with later. We have therefore opted to maintain the overweighting in duration on core European debt. We have underweighted duration in European periphery debt, as we believe that valuations remain forced and the return-risk profile is geared to the downside, as the expected supply will cause a significant increase in spreads. 

Finally, the macro context in the UK, with high inflation and weak growth, raises questions about the risk of stagflation. We chose to remain neutral on the British duration, due to its reasonable valuation.  

How to successfully navigate the next monetary policy cycle?

Bond yields remain at their most attractive level since the 2008 financial crisis. In other words, investors can still earn returns in excess of liquidity without having to compromise on quality or extend duration. However, it is necessary to analyze under a microscope the different assets that make up this vast investment universe. For example, we are neutral on global investment grade corporate bonds, but when analyzing these by region, we believe that the valuations of US investment grade bonds are still extremely high and we prefer their European equivalents because we believe their spreads are still attractive. 

In short, we believe that the high level of uncertainty in the markets justifies a flexible, global and unbiased approach to sectors, issuers and credit ratings in order to successfully navigate the next monetary policy cycle.