At the beginning of the year, we sat down with Michael Goosay, Chief Investment Officer, Global Fixed Income, to discuss his outlook for the fixed income markets in 2024, where he sees opportunities, and potential performance drivers.

Q: In many ways, fixed income markets felt like a mixed bag in 2023. Do you expect continued challenges for fixed income investors in 2024?

2023 was a challenging year with a few drivers of volatility in the fixed income markets, some of which were not traditional. Central banks worldwide have just come through an extended period of tightening policy with no clear end in sight for a long time. Economic data showed signs of weakening, but inflation remained well above its target. As we come into 2024, there seems to be more clarity – inflation is still above most central banks’ comfort levels but trending lower, and there are signs that economic growth might be slowing but not to a recessionary level.

Given the slowdown in growth, the economy is at a point where central banks can start to think about shifting away from restrictive monetary policy into a more accommodative stance. As 2024 starts to get into full swing, we anticipate that fixed income will be an attractive asset class as the economic tightening cycle turns into a pause in and an easing of policy. Historically, this has been a good time to start buying fixed income.

Rates have historically peaked around last Fed hike
10-year U.S. Treasury and Fed funds rate, 1985–present

Alt text for the image: 10-year U.S. Treasury and Fed funds rate since 1985
Source: Bloomberg, Federal Reserve, Principal Asset Management. Data as of February 7, 2024.
Q: You mentioned that central banks, particularly the Federal Reserve, might be looking to cut interest rates in 2024. Are all global central banks aligned in the view?

Unlike the Federal Reserve (Fed), many global central banks have less opportunity to ease policy in 2024 and beyond. In many cases, they did not tighten policy nearly as much as the Fed. We have already seen the impact of higher rates on the U.K. and many European economies. Much of the pass-through of higher rates in those economies has been felt because European mortgages tend to be floating rate, which react much quicker to changes in central bank policy. Conversely, U.S. mortgage rates and consumer borrowing costs are much slower to respond to changes in Fed policy rates because we have longer fixed-rate maturities in our housing and credit card markets.

While we have seen the risks of higher rates play out in the European and U.K. economies, these risks have yet to be felt in some Asian economies. Japan, for example, has had a zero-interest-rate policy and substantial quantitative easing for decades, so we are just starting to see inflation evolve as a result of that aggressive policy. Going forward, we anticipate that the Bank of Japan will lag behind the Bank of England and the Fed in adjusting monetary policy.

Q: Focusing on the Fed, what pace of rate cuts are you anticipating in 2024? Will it be an immediate and steep decline or a more reserved pace?

The bond markets have two conflicting viewpoints on the path and pace of Fed rate cuts. On one side, we’re seeing a cohort of investors adamant that the Fed needs to move monetary policy quickly. They argue that we have already seen signs of cracking on the consumer side and that the implications of higher rates on consumer and residential real estate will become very evident in the first half of 2024. Because of this, these investors believe that the Fed should cut policy rates aggressively and rapidly in the first half of the year.

Conversely, some investors believe the Fed will likely be more patient and cut policy rates slowly and methodically over the second half of the year. They see the consumer as stretched but in relatively good shape, while companies still show reasonable earning numbers. When looked at alongside still strong employment data – the most important data print for the Fed – we find ourselves more aligned with this viewpoint. While we see signs that the consumer is deteriorating in terms of quality and worsening earnings numbers, albeit at a slow pace, we believe the Fed will want to see that inflation has been fully tamed before starting to cut policy rates.

We anticipate rate cuts to start in the by the third quarter of 2024, but we expect these to be larger and more aggressive rate cuts aimed at having a more significant impact on the economy in a short period of time.

Q: Given your economic outlook, what should investors be looking to recruit for their fixed income investments in 2024? Are there any specific asset classes that will benefit from the anticipated macro environment?

Traditionally speaking, when the Fed begins to pause and ultimately cut policy rates, it is an opportune time to take more interest rate risk through duration, shifting overnight money market funds into longer-duration assets. We are looking at longer-dated, high-quality instruments – agency mortgages and higher quality investment grade corporates, for example – as attractive as long as their interest rate and credit sensitivity are maintained. Additionally, municipal bonds are an option for investors as they are an attractive place to shift money during a turn in the cycle and are a viable way to get tax advantage returns in the fixed income marketplace.

Areas of fixed income that are a bit more sensitive to slowdowns in economic growth, such as emerging market debt or high yield, are places where investors should be more cautious, where active management and differentiated strategies will be paramount. These are areas in which the companies and countries are a bit more leveraged relative to some of the higher quality investment grade or U.S. government-guaranteed issuers. While the timing remains a challenge, what has been evident over time is that extending duration when central banks pause or move toward an easing cycle is an advantageous first move, followed by buying assets with a bit more associated risk once a slowdown or a recession hits.

Q: What factors should investors focus on in fixed income investing right now?

Three main characteristics make fixed income an attractive asset class. First and most obviously, there’s income, and the yields investors are getting today are significantly more attractive than they have been for the last decade plus. Second is the total return opportunity. Given the substantial increase in rates over the previous year and a half, we expect a total return consistent with what an investor would get in an equity portfolio. The third is the diversification benefits that fixed income enables in an investor’s portfolio versus the rest of their allocations. When fixed income is performing well, it typically means that alternative assets and/or equities are not performing as well. These three factors – income, total return, and diversification – are why fixed income should play an essential role in any investor’s portfolio today. 

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Risk Considerations
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results and should not be relied upon to make an investment decision. Fixed‐income investment options are subject to interest rate risk, and their value will decline as interest rates rise. Potential investors should be aware that Investment grade corporate bonds carry credit risks, default risk, liquidity risks, currency risks, operational risks, legal risks, counterparty risk and valuation risks. Lower-rated securities are subject to additional credit and default risks. Emerging market debt may be subject to heightened default and liquidity risk. International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards. Asset allocation and diversification or a downside risk reduction/protection strategy do not ensure a profit or protect against a loss.

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