Balancing growth and inflation

Federal Reserve officials and market participants seemingly agree on one thing in their outlook for 2024 – they expect interest rates to decline. While both parties agree on the general direction of interest rates, they disagree on the pace at which this could happen. Market participants appear to be discounting an earlier and more aggressive rate cut cycle, while the Federal Open Market Committee (FOMC) favours a gradual decline.

At this stage of the economic cycle, the balance of risks for monetary policy appears asymmetric. In the pursuit of a soft landing, policymakers would be more inclined to cut interest rates in the face of growth risks as opposed to hiking rates to curb inflationary pressure. Slowing growth and enduring disinflation trends could increase the willingness of policymakers to calibrate the current restrictive stance in monetary policy, even if inflation has not reached the target level.

Bonds could regain their lustre

While the path to policy easing in 2024 could be bumpy, it still presents a constructive backdrop for fixed income. 

• From the outset, yields typically fall after a central bank’s final rate hike, which has historically coincided with meaningful capital gains for fixed income.
• Furthermore, with yields across many fixed income sectors hovering near decade highs, it could be opportune to lock in elevated yields as central banks approach the end of their rate hike cycles.
• Higher starting yields tend to be a good indicator of forward returns. More importantly, they present an income buffer to cushion against potential capital losses should interest rates rise or credit spreads widen.

These factors suggest that some allocation to bonds in a diversified portfolio, based on an investor’s investment objectives and risk appetite, could create a meaningful impact from a total return perspective.

Finding the sweet spot between quality and value

While the field of fixed income opportunities is wide and diverse, several sectors present relatively attractive risk-reward.

• Duration¹: Over the last seven rate hike cycles since 1981, duration tends to outperform after interest rates peak, as illustrated below². Furthermore, the high correlation between stocks and bonds in 2022 has moderated somewhat, potentially allowing the traditional and useful diversification properties of duration to reassert itself. While short-duration assets continue to play an important role in portfolios given higher front-end yields and volatile market conditions, investors should calibrate their short-duration allocation as the potential for policy easing comes into view. 

• Agency mortgage-backed securities³ (Agency MBS): Agency MBS – pools of securitised residential mortgage loans that are issued or guaranteed by US government agencies – can present a high quality income stream for bond portfolios, especially against a softening macro backdrop. These assets are typically investment grade, tend to exhibit lower credit risks and are generally very liquid. Amid elevated credit spreads, valuations of the sector look relatively attractive, in our view. Moreover, new issuance of agency MBS has been muted amid a general dearth of new mortgage origination and refinancing, largely driven by higher interest rates. This typically translates to greater cash-flow stability.
• Commercial mortgage-backed securities (CMBS)³: There are pockets of opportunities in the CMBS sector. While office commercial real estate debt remains under pressure, residential rental real estate debt continues to be supported by decent fundamentals. In particular, rents have remained relatively resilient on the back of high mortgage rates that have discouraged buying and kept many people renting – market dynamics that continue to support the sector.

Unconstrained, flexible, bottom-up

Currently, fixed income presents a wide opportunity set for some investors to lock in relatively higher yields for longer. Yet challenges remain, spanning market volatility and recession risks. This underscores the importance of adopting an active, unconstrained and flexible approach to seek out enduring opportunities for yield and harness the income potential across both traditional and extended fixed income sectors.

At J.P. Morgan Asset Management, we strive to construct stronger bond portfolios with robust risk management⁴. We manage over US$2.8 trillion in assets, with around US$710 billion in fixed income⁵. Our fixed income solutions span the risk spectrum and are underpinned by the deep resources and rigorous research of a truly global platform.