Key points
- The combination of heightened volatility and increased dispersion should create some great potential alpha opportunities in rates markets.
- The US dollar is at risk of weakening as the US economy is hitting late cycle and the Federal Reserve looks set to pause hiking before most peers.
- Given the uncertain backdrop of sticky inflation and slowing growth, volatility is likely to remain high, so a flexible approach to bond investing will be important.
Bond volatility is likely to persist as concerns continue over sticky inflation, slowing growth, the banking sector, and the US debt ceiling standoff. Through this volatility, we are finding potential attractive alpha opportunities in the rates space amid increased dispersion in central bank policy. In risk markets, the window of opportunity to add credit risk may have passed for now. While fundamentals continue to be supportive, we feel that risk markets may face challenges ahead from slowing growth or further market stresses, which is a possibility given the sheer number and pace of interest rate hikes since 2022.
Overall, we believe this environment will suit the Dynamic Global Bond Strategy, which has a strong emphasis on active duration management and is flexible with the ability to tactically respond to different market environments.
Conditions Ripe for Potential Alpha Opportunities in Rates
In rates, we believe that the current landscape is more conducive for generating alpha as heightened volatility creates dislocations that we can potentially take advantage of. One example here is the U.S., where banking turmoil led to markets pricing in multiple interest rate cuts later this year. While the Federal Reserve may pause rate hikes soon, we believe it is unlikely that it will then switch to cutting interest rates so quickly given the current US inflation and labour market dynamics.
Our base case is for US rates to stay higher for longer than markets currently anticipate. Why? Price pressures are cooling, but only moderately and not likely fast enough to force the Fed into an early cutting cycle given that inflation remains materially above its 2% target. It is a similar story in the labour market, which may be loosening, but only gradually and from a position of extreme tightness. With this backdrop, US rate cuts are probably off the table for 2023, so we expect the two‑year US Treasury yield to reprice higher. Eventually, the Treasury curve is likely to steepen or normalise as the current hiking cycle comes to an end. This is a long‑term view that we believe will play out over several quarters.
This post was funded by T. Rowe Price
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