How have market expectations of monetary policy impacted the Dynamic Duration Fund?
Investors left 2023 with a sense of euphoria that central banks had finally ended their rate hiking cycle which had ravaged the bond markets. We were surprised at how well global markets had digested the most aggressive rate hiking cycle since the 1970s. Before the recent 500bps increase, the record was 425bps in 2004, while the long-term average rate cycle from the Fed is 300bps. Interestingly, the average duration of a Fed hiking cycle is 21 months (max 36 months), so although this has been a painful 25 months it perhaps is nearing the end. *
Investor optimism was brought to abrupt end in Q1 as the market grappled with a series of disappointing inflation data releases. Market expectations of 2024 rate cuts plummeted from 6-7 to 1-2 in the space of 3 months. The chart below shows the number of interest rate cuts by year end, typically in decrements of 0.25%, expected for UK in yellow and US in blue. Given the varying market dynamics and inflationary pressures, expectations for rate cuts have shifted somewhat in unison.
Expected number of cuts
Source: Bloomberg, 29-12-23 - 06-05-24
We heard from Federal Reserve Chair, Jerome Powell, recently who gave some reassurance that the next rate change is likely to be down, not up. Powell asserted that the current restrictive monetary policy should gradually steer inflation back towards the target, although this process may take longer than anticipated. Effectively ruling out a rate cut in the near term—a material shift—given the market had been pricing in rate cuts as soon as March this year.
With the UK's economic data showing relative weakness and inflation figures softening, the situation in the UK starkly contrasts with that of the US. The looming question is whether the Bank will pre-empt the Fed by initiating rate cuts sooner. The Governor of the Bank of England, Andrew Bailey, is attempting to steer the MPC towards cutting rates sooner and although we are unlikely to see a cut right now, the votes may tip by the June meeting. One might wonder what impact the increasing pressure from senior conservative MPs on the BoE to cut rates will have on the voting. Sir Jacob Rees-Mogg criticised the BoE, saying, "It (BoE) was slow to increase them and now seems stubborn in keeping them at current levels". Perhaps comments like this will only intensify as the government hopes rate cuts will create a "feel-good factor" for voters ahead of possible Q4 general election.
What does all this mean for our Dynamic Duration Bond Fund? The latest signal change for the fund was in December, when it moved from overweight US bond exposure back to neutral. This has been a welcome change, as the fund moved away from bond exposure, which has been negative, and into inflation exposure, which has been positive. Core inflation dropping to within 3% would signal increasing fixed income exposure again. The UK signals are also neutral, so similar exposure to fixed income and inflation, but with a different signal composition. We'll expand on this after the Bank of England meets this afternoon.
Source: Federal Reserve Bank of St. Louis, May 2024
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