David Kelly:

Welcome to Insights Now, a series of conversations designed to shine a light of clarity on the complex world of investing. As we conclude this season, which we entitled A Bond's Eye View of the World, a lot of core arguments for adding fixed income at the start of the year still remain in place. So far, the Fed has continued to hike rates, but they may finally be the end of their tightening regime and if we are at peak rates, that means now is the time for investors to lock in yields before they fall.

Bonds could also provide portfolios with important diversification properties as we eye this next downturn. So as investors take a closer look at their cash and bond holdings, we hope this season has helped shed light on the different opportunities within bonds and how to think about duration, credit and income within portfolios. To wrap up our last episode, I've invited my colleague, Bob Michael, CIO and head of our global fixed income currency and commodities group here at JP Morgan Asset Management for conversation on his outlook for the economy, the Fed, and ultimately bond markets. So Bob, welcome back to Insights Now.

Bob Michele:

Glad to be here.

David Kelly:

For starters, let's get a sense of your views on the economic outlook. The regional banking crisis seemed to increase the odds of recession this year, but recent numbers have underscored the economy's continued resilience. So what do you think the risk is of a hard landing this year, or are we now talking about recession in 2024?

Bob Michele:

Well, I think that's a very good question. We're still on board with recession by year-end. Typically, the average recession in the US has been about minus 1.6% real GDP. We think it will be about there, maybe as much as minus 2%, but the data is stacking up in a way which tells you that recession is pretty much unavoidable. Let's start with what the Fed has done. A 500 basis point rate shock in a year. You've never had that and not gone into recession. Then you throw quantitative tightening on top of that. Let's look at the yield curve. Every part of the yield curve has inverted. Let's go to the one that Jay Powell himself manufactured, three month treasury bills versus what the futures market is pricing in 18 months from now on three month treasury bills. I didn't even know it existed. That's at its greatest inversion ever.

And you know what? He's right. That's a perfect indicator of recession. Then there's a load of other data out there. Credit conditions are tightening everywhere. You mentioned the crisis at the regional banks. We look at senior loan officer opinion surveys. That's at the most negative reading for credit conditions tightening that we've seen outside of recessions and there are many other things. There's talk about the labor market remains pretty firm. We look at the rate of change in continuing claims. It's rising at a rate that you only see in recession, so we're pretty certain we're headed into recession. It looks to us recession by year-end.

David Kelly:

There's also some concern that inflation's not coming down fast enough for the Fed. How do you see disinflation progressing over the next few quarters and do you think there's still a reason for the Fed to keep policy extraordinarily restrictive here?

Bob Michele:

Thank you for using the term "disinflation" because you are right, inflation has been coming down. The peak in the CPI was 9.1% back in June of last year. We're currently about half of that at 4.9%. If you look at core CPI, yeah, that's been a little stickier. I think it's dropped from 6.6% year over year to 5.5% year over year. But there are signs that that's about to drop a lot. The major signal to us is looking at commodity prices. That's the cost of raw materials to go into everything. That's down 20% year over year. You never see that kind of drop outside of recession. Then you look at the core engine of Industrial America, the National Federation of Independent Businesses, their pricing plans are the lowest since 2020, so we're in a period of disinflation. Inflation will be substantially lower over the next couple of quarters. The Fed for sure can leave rates where they are for now, but they don't need to go any higher.

David Kelly:

Well, that's right. I completely agree with you, Bob. Particularly on inflation, it's clear that it's coming down anyway, so why push your luck if you're the Fed? But nevertheless, Fed expectations have been changing day to day and recent pricing shows that markets do see a significant possibility of a Fed rate hike in June. Do you think that they will actually opt to hike again or are they going to pause this month?

Bob Michele:

Sounds like they're telling us they're going to pause, which they should do because for the last couple of years, they've talked about the long and variable, the cumulative and lagged impacts of changes in monetary policy. Well, as I said, we've just gone through a year of 500 basis point in rate hikes. We're still running down the balance sheet of up to $85 billion per month. That's a lot hitting the economy at once. They should pause here. They should see what happens. We'll know more by the July meeting. We'll know a lot more by the September meeting. Our view is we've seen the last of the rate hikes.

David Kelly:

So sticking to this on the subject of what people expect from the Fed, one thing we've been trying to make sense of is that the Fed funds futures contracts at various times this year have seemed to differ from what economists actually see rates ending up at. If you look at, for example, Bloomberg's monthly forecaster survey, how do you explain this difference in signals here?

Bob Michele:

That's a question we're getting a lot these days from our clients, and we have to remember that that Fed futures market is a probability weighted distribution. And simply put, every time the Fed has gone into a rate cutting cycle over that next 12 months, they've cut rates about 200 basis points. If you think there's a 20% probability that they're going to embark on that cycle, an economist would say, "Are they going to cut rates or not?" One in five? No, but the futures market is going to price in 40 basis points of rate cuts. They're going to take that 20% probability of the 200 basis points they typically do. That's what we're seeing in those markets. That explains the disconnect.

David Kelly:

That's a very interesting and clear way of explaining this paradox. Let's touch on the yield curve here. Long rates haven't moved much this year, but are you still long duration in this environment and how do you differentiate along the curve?

Bob Michele:

We're still long duration. We've been buying every backup. Certainly we expect the Fed to come in and start cutting rates before the end of the year. They typically do halfway between the last rate hike and when recession starts to hit. So if we expect recession by year-end, we're expecting the first rate cut in September. Once more of the market starts to believe that, the yield curve tends to disinvert, we're seeing some of that, and then eventually steepens. So we want to be part of locking in higher rates where they are today. So as I said, we've been buying back up in yields. We've been buying the intermediate part of the curve. The five-year part of the curve is a sweet spot to us. That should benefit a lot from being further out from cash, but also giving you some duration and yield when rates fall.

David Kelly:

And are we still cautious on credit?

Bob Michele:

We own a lot of credit, but it's investment grade credit. We haven't yet bought a lot of high yield in the accounts that are able to do it because typically when you go into recession, high yield tends to drop in price. People are concerned about corporate profitability and the market adjusts to that. We think high yield is a trade for later in the year, but right now, high quality corporate bonds, high quality mortgage backed securities, high quality securitized debt, all of those things make sense to us now.

David Kelly:

So last year, the correlation between stocks and bonds turned positive in what was a very tough year for investors across asset classes. Do you think that we've now gone back to this more traditional inverse relationship between stocks and bonds?

Bob Michele:

Happily, yes. We feel we're back to an environment where they counterbalance each other. If equities tend to drop in price, then fixed income should go up in price. And conversely, if it's a good time in the equity market and they start to go up, then the need for the safety of the bond market tends to fade away and bonds generally drop in price. We're okay with that relationship.

David Kelly:

Back in the year of near zero yields, many investors looked at alternatives as a substitute for fixed income to generate income. Do you think that thesis has now changed?

Bob Michele:

At a time when the central banks were heavily in the markets distorting them, and as you point out, we had not only zero yields, but we had $18 trillion of negative yielding debt out there. That's quite a bit of negative yielding debt. Investors were searching for alternatives and the allure of the private capital markets was there, but now you've had a repricing of the bond market. That doesn't go back to just the last several years. It actually goes back to 15 years ago. The last time we had real yields this high in the bond market was 2007, 2008. That's starting to bring investors back to traditional asset classes again. One of the things we've looked at in conversations we've had with our investors is that the end of 2021, the general aggregate bond market in the US yielded 1.7%. Today, it yields 4.5%. With some active management and identifying cheaper sectors, you're close to 5%. That's material difference. That's bringing investors back.

David Kelly:

Within fixed income overall, given everything you say, where do you think the best opportunities in fixed income are right now?

Bob Michele:

We like high quality duration. We like the investment grade corporate bond market. You can buy intermediate credit at close to 5%. We like the agency mortgage market. Again, you're in that 4.5% to 5% yield. We like securitized credit. Depending on the structure, we buy anywhere from 4% to 6%, and there are a couple things that we like in emerging market debt. Only sovereign debt, local market debt where the central banks have done a lot of rate tightening. We can cherry-pick yields in those markets at over 7%.

David Kelly:

And finally, as we wrap up the season on a Bond's Eye View of the World, what would you say have been the most important lessons for bond investors over the last year? And if I can add, after a long period of near zero interest rates before 2022, do you think that this cycle has started a new regime for bonds, and if so, how would you define that?

Bob Michele:

Okay, that's a lot of questions there. I think what we've learned in the last couple of years is there's a time to buy bonds and there's a time not to own bonds. And if you go back actually to 2020, 2021, 2022, those were the times not to buy bonds or own bonds, but they were two very different regimes. One is the central banks came in, distorted the markets, brought yields down to zero and kept buying bonds to keep yields at zero. So the value proposition certainly wasn't there. I don't argue with anyone who went into equities or alternatives at that time. Then 2022 was a different kind of problem for the bond markets because the central banks realized it was time to normalize rates. They started that process and suddenly bond markets were down 15%. We had never seen that. So when central banks are raising rates, you want to avoid it.

But now we're in the environment where it's time to buy bonds. They've raised rates. We're at very high levels of real yields. You can put money in the market at 5%. That's the time to buy bonds. Do I think we're in a different regime? It feels like it. It feels like the last 15 years were the distortion in the bond market. Maybe it was the last of the transition from baby boomers to the X, Y, Z generation. I'm open to that. But it feels like there's real demand for capital. There's going to be a real cost of capital, and we're in an environment where maybe that very first median dot that the Fed put out there in 2012, it was 4.25%. That was their textbook answer day one on what a neutral Fed funds rate was. We think we're headed back to that environment.

David Kelly:

A new new normal.

Bob Michele:

That's our hope.

David Kelly:

Thank you so much for joining us, Bob, and thank you all for listening.

As I mentioned, this concludes our sixth season of the Insights Now podcast. We won't be gone for too long. This summer, we'll be back with a miniseries featuring a handful of conversations on some of the top investment themes for markets these days, things like generative AI, the state of the world post COVID, and how the newest generation of investors is changing up the marketplace. This miniseries will kick off in July so stay tuned for more.

We'd also like to hear your thoughts and any suggestions you may have on our podcast as we plan for our next season. You can reach out to our team market insights at miquestions@jpmorgan.com. We'll also provide the email in the show notes for this episode. Apart from that, I invite you to read or listen to my notes on the week ahead podcast, where every Monday I share commentary on the latest in the markets and the economy to help you stay informed for the week ahead. For even more timely insights, you can also follow and subscribe to my content on LinkedIn.

Disclaimer:

This content is intended for information only based on assumptions and current market conditions and are subject to change. No warranty of accuracy is given. This content does not contain sufficient information to support investment decisions. It is not to be construed as research, legal, regulatory, tax, accounting, or investment advice. Investments involve risks. Investors should seek professional advice or make an independent evaluation before investing. The value of investments and the income from them may fluctuate, including loss of capital. Past performance and yield are not indicative of current or future results. Forecasts and estimates may or may not come to pass. JP Morgan Asset Management is the asset management business of JP Morgan Chase and Company and its affiliates worldwide.