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Where are global rates likely to settle from here?

26 February 2024 Ninety One

Now that global rate cuts are on the horizon, what will this mean for yield-hungry investors? Paul Carr and Adam Furlan, portfolio managers for Emerging Market Fixed Income at Ninety One, analyse the outlook.

With global interest rates close to 17-year highs, conservative investors are benefiting from a generous yield environment. The consensus view is that interest rates have peaked, but markets have had to dial back their expectations on when the US Federal Reserve (the Fed) will kick off the rate-cutting cycle this year. We expect the absolute levels of yields to come down gradually over the next 12-24 months. In our view, the normalisation of global inflation will be the primary driver of rate cuts rather than a late-cycle collapse in economic growth.

In a recession, central banks end up cutting rates aggressively to support growth, but the current environment is different. Global growth, especially in the US, has been resilient and the growth outlook remains strong. So we are in a period of inflation normalisation and, ultimately, this means that we can expect the Fed to engineer a gradual rate-cutting cycle. We believe the environment will remain attractive for yield-hungry investors, as rates are not going to come down as aggressively as they did in previous cutting cycles.
It's also important to highlight that when yields come down, bond prices are generally supported. This presents an opportunity for investors to enjoy a potential capital uplift when interest rates come down.

Market’s rate outlook may be too aggressive
The timing of the first rate cut in the US remains uncertain and will be data dependent, with the Fed keeping a close eye on inflation and growth numbers. The Fed regularly shares its forecast on where rates should move over the next 12 months. Currently, that forecast points to three rate cuts of 25 basis points each in 2024. The market, on the other hand, seems to be assuming that there will be a more aggressive rate-cutting cycle of between four and five cuts of 25 basis points each for this year. We believe the market’s pricing is too aggressive, and we are more aligned with the Fed’s projected interest rate cuts for the year. Our view is that global growth should remain supportive, as interest rates are gradually lowered. This means that conservative investors will still have an opportunity to earn attractive absolute returns above healthy yields in dollar cash.

Positioning for a shifting rate environment
We have been reducing the overall duration risk in our Ninety One Global Diversified Income portfolio as we don’t believe US rates will come down as quickly as the market is anticipating. We expect the US economy to gradually slow down over the coming quarters due to a deteriorating services sector as monetary policy operates with a lag, excess savings are run down, and labour markets rebalance from very tight levels.

However, we don’t believe the economy will fall into a deep recession, and our high-conviction view is that the US economy will have a soft landing. Resilient US growth should be supportive for markets and underpin credit spreads. We have gradually been increasing the credit exposure in the portfolio to take advantage of attractive income opportunities.

From a bottom-up perspective, we are invested in UK bonds because we believe growth will be weak in the UK and inflation will also continue to surprise on the downside. We expect the Bank of England to have more rate cuts than consensus expectations currently show.

A notable diversifier for the portfolio is our dollar exposure relative to the Japanese yen, driven by one of our core policy divergence themes in the portfolio. Ultimately, this is a highly attractive way to reduce volatility in the portfolio through the correlation between the Japanese yen and short-dated US interest rates. While we target a dollar cash-plus return for our investors, we remain firmly focused on diversification and reducing downside risks within the portfolio.

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