FidelityConnects: The Fed Decides: What it means for bond investors

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<b>Subtitles are AI Generated</b>

 

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Hello, and welcome to Fidelity Connects.

 

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I'm Pamela Ritchie. The Federal Reserve has held its key interest rate

 

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unchanged. With uncertainty rising around growth, inflation and

 

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geopolitics our next guest suggests this may be the kind of backdrop where

 

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US Treasuries regain attention as a potential safe haven within

 

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fixed income. With credit spreads beginning to shift this

 

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only reinforces the value of holding quality and maintaining

 

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flexibility. How should investors think about positioning

 

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fixed-income portfolios in this environment, and what could increased

 

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volatility mean for the way investors approach Treasuries?

 

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Joining us here today to take us through her thoughts

 

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on the latest rate decision and its potential implications for bonds and beyond

 

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is institutional portfolio manager, Christine Thorpe.

 

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Hello, Christine, very nice to see you.

 

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How are you?

 

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Hi, Pamela. I'm well, thanks for having me.

 

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We're delighted to have you join us, and we'll invite everyone joining you here

 

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today to send questions in over the next 30 minutes or so, we can put those

 

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to Christine.

 

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You, at Fidelity, are very much attuned to

 

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a longer term story.

 

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That said, what's going on in the shorter term story is just mind boggling

 

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and the volatility across asset classes has

 

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been enormous. I wonder if you can set us straight on just how quickly

 

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you've had to react to everything that's going on right now and how different

 

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that is from the beginning of the year.

 

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I think you're right, Pamela, to dial

 

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in on that long term perspective because that's certainly

 

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how we think about investing our clients' assets.

 

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Coming into this year, and this has been pretty consistent for

 

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a while now, we really had taken risk down

 

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across our portfolios.

 

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I'd say that really was based on the fact that while

 

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the fundamentals have actually been decent valuations have

 

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been incredibly tight or rich.

 

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Across our suite of fixed income portfolios

 

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that's really meant we've had a lot of dry powder

 

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in terms of US Treasuries within our portfolios.

 

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Really, our thought has been Treasuries

 

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have been really attractive from a risk-reward perspective and

 

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at the same time, like I said, with credit spreads being so

 

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tight you just weren't getting really compensated to take on

 

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a lot of risk.

 

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I'll say most of the yield in credit was

 

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actually coming from rates.

 

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That's felt to us like a pretty good trade-off, take down the credit risk,

 

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have a lot of dry powder.

 

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Certainly still risk-on in our portfolios.

 

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We've been outyielding the benchmark.

 

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It's not to say that we don't have any risk but I would just characterize it as

 

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being towards the low end of the spectrum relative to

 

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where we've been historically.

 

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Even with all of the news flow and the headlines we're seeing,

 

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Pamela, there actually haven't been a lot of opportunities

 

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to deploy that dry powder.

 

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Credit spreads have been fairly well behaved, leaking a little bit wider

 

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in the midst of this volatility but not a

 

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huge opportunity to go out and add a lot of risk, so continuing

 

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to really lean into the same themes as where we started this year,

 

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patience being, I would say, our top idea and also emphasizing

 

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the importance of diversification.

 

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That's very comforting in the midst of what can be

 

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a little bit like watching a tennis match going back and forth between so many

 

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different voices and very serious events going on in the world to know that

 

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you have sort of a consistent view on where the value of the market is and

 

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that's where you're staying and sort of at the ready.

 

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Enter the decision from the Fed which was made

 

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along with all kinds of other fundamental pieces but, obviously, trying to deal

 

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with the fact that the price of oil has spiralled and gone up

 

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so the inflation question very much comes back to the fore.

 

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Just give us your thoughts on maybe the decision.

 

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I think most people are pretty acquainted with the decision at this point but

 

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really sort of what it means, I guess, a bit longer term for investors.

 

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You're right, the market was pricing that the Fed would be

 

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on hold so no surprise from that perspective

 

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coming out of the meeting this week.

 

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If we look at the projections the Fed put forth they

 

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are still holding to potentially one cut for

 

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the remainder of this year and then perhaps another cut in

 

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2027.

 

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Growth was slightly upgraded but I'll say

 

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Chairman Powell is pretty clear in cautioning investors

 

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to perhaps not pay too much attention to the projections they

 

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put out just given the degree of uncertainty

 

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there is in the market.

 

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I would say Chairman Powell's comments and the way the market read

 

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the FOMC statement was definitely

 

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leaning towards the more hawkish side of things.

 

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He certainly was leaning into the concerns around

 

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inflation coming on this oil price increase.

 

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The market certainly was in line

 

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with that. Even today we're continuing to see

 

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expectations around the Fed cutting this year continue

 

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to get priced out.

 

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There's clearly this narrative of

 

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oil is going to continue to play havoc on inflation

 

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expectations so we should be prepared for the

 

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Fed to be on hold for a while longer.

 

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I'd also say, interestingly, Chairman Powell also alluded

 

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to the fact that ...

 

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or I should say explicit about the fact that he plans

 

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to stay in his seat until the Kevin

 

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Warsh nomination and confirmation process has concluded.

 

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It's still an open question as to when that will happen.

 

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In addition to that he's going to stay in his seat

 

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on the Board until the investigation against him

 

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has been fully concluded. I think, certainly,

 

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giving the administration a lot to think about

 

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in terms of whether it makes sense to sort of move

 

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the investigation, conclude it, so that they can continue

 

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to have perhaps a board that's more friendly to the

 

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administration's desire to get rates lower.

 

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Do you think that provides stability to the market for

 

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the Chairman to be explicit about he's staying until this conclusion?

 

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Is it useful in either direction or is it

 

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sort of a nothing in a way?

 

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I think we've had this narrative out there, the questions around how

 

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independent is the Fed going to be?

 

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For all that debate we haven't really seen that

 

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bleed into longer term rate expectations.

 

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Longer term rates, sort of putting aside some of the more

 

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recent activity, were pretty well behaved so

 

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I think the market was really sort of feeling like,

 

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hey, the Fed is going to maintain its independence, that's obviously incredibly

 

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important, but I think it does perhaps

 

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create an environment where the Fed could continue to be a little bit more

 

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hawkish as they place more of an emphasis on the inflation side of

 

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story rather than the labour market.

 

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I think it's early days but certainly important to

 

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see Chairman Powell putting that stake in the ground.

 

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It's so important to get your thoughts on that because you're watching where

 

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markets are telling you things are going and a lot of us get stuck in the

 

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headlines so it's just really important to kind of hear what the market is

 

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quieting there. In terms of analogies to past situations,

 

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2022 is not so far in the past and it was a situation where

 

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inflation essentially meant that equities and bonds went down together.

 

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Some will say there's some muscle memory, there's some fear that that could

 

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happen again when you see inflation for reasons of oil or other reasons

 

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come on back.

 

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How do you address that?

 

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You're right, we're back to that sort of positive correlation that

 

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we saw back in 2022.

 

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We're continuing to see that play out here.

 

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As we think back to the 2022 period,

 

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the rise in oil prices coming out of the Russian invasion into Ukraine,

 

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the inflationary backdrop, I would say, was a little bit different at

 

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that point. This is when we were starting to hit

 

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9% inflation. We've certainly come off those highs.

 

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I think no question inflation has continued to stay

 

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stickier than the Fed would like as we're still well above

 

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the 2% target.

 

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I would draw a distinction between the inflation backdrop

 

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back then versus where we are today.

 

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Now, other sort of interesting points, I would

 

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say in 2022 the consumer was still

 

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riding all the fiscal stimulus

 

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coming out of the COVID period

 

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so they had a decent amount of cushion to help with the

 

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oil prices. The parallel there I would draw

 

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is the consumer does have some support

 

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coming through the tax legislation and the

 

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One Big Beautiful Bill. I think there is still a question

 

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of how much of this increase in prices at the gas

 

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pump, what is the ultimate impact going to be to the

 

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US consumer with that sort of fiscal backdrop.

 

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Certainly, I would say that the longer that

 

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we are in this elevated oil price environment and the degree to which

 

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the prices increase, that's going to have significant impacts

 

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for potentially leading us to more of a slowdown in the

 

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US economy.

 

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That comes back to the Fed and sort of their path forward if we

 

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get more into that recessionary type environment, that's

 

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when we can get back to perhaps the Fed resuming the cutting cycle.

 

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The big story on the fiscal side, as you say, is the components of the

 

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One Big Beautiful Bill that are sort of the refunds that are meant to come

 

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through the spring period and to what extent.

 

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This comes to that question of whether the oil price shock for

 

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US consumers is offset by exactly what you said, the tax refunds,

 

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and if that can allow what's going on now to be just called

 

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transitory.

 

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Could you make a call one way or the other on that?

 

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Would you dare to? I know it's hard to make a call.

 

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You're right, and that was sort of the rhetoric

 

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from the Fed. We have to bear watching.

 

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I think some of the work that they've done has

 

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pointed to perhaps these higher

 

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oil prices don't necessarily have a huge impact

 

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on core goods when we think about it from that

 

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perspective. Again, I think that's where really

 

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the duration and the level of oil prices just on the

 

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broader impact is going to be really important from

 

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that perspective.

 

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I might just add to that the position from sort of a regional,

 

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global basis that perhaps the American consumer, because

 

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of the tax refunds and dealing with oil at the same time, is it in

 

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a better position because it has this fiscal backdrop, this sort of

 

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wind at its back on some level to afford what's going

 

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on, and does that change the story and make

 

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a US exceptionalism story kind of creep back in that particular way.

 

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What do you say to that?

 

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I don't know if anyone is exceptional in this

 

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period where we have these ...

 

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but your point is well taken, Pamela.

 

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I think it is fair to say that there's probably a distinction between

 

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how the US may navigate

 

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this type of energy shock relative to other

 

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areas across the globe.

 

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I'd call out specifically Europe and Asia where

 

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there's typically been a much higher dependency on

 

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oil being imported, as

 

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well as higher reliance on natural

 

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gas. If you take the Strait of Hormuz about 20%

 

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of the world's LNG supplies go through

 

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that. That's why we're seeing, I would say, much higher impact

 

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on energy prices in

 

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Europe and then also across Asia.

 

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I think it's not surprising when we look at some of the central banks,

 

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for example, the Bank of England or the ECB,

 

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their rhetoric I would characterize as being even more hawkish

 

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than what we've seen here in the US, perhaps even

 

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cautioning that a hike could be in the foreseeable

 

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future. That's where I think there is this distinction.

 

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The US, we've certainly made a lot of

 

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progress in terms of a higher degree of energy independence

 

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with our focus on the oil shale.

 

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Also just broadly, we're very much

 

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a service-based economy so that helps reduce the

 

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overall impact from higher oil prices as well.

 

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Nobody escapes here but I do think there are some areas

 

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that could be harder hit in this backdrop.

 

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It's interesting, and these are all leading to, I think, what you said off

 

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the top of why you remain invested the way you're

 

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invested and that hasn't really changed.

 

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I'm curious a little bit about the global story and again, where it

 

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puts sort of the US bond market because, as you mentioned, many of those

 

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countries before the oil shock that's going on right now due to the war had

 

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finished their cutting cycles, essentially.

 

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I mean, they've been sitting at the bottom or close to it and

 

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had started cutting earlier so the differential had been there already.

 

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Again, I guess, just weave that into your thesis for how you are investing.

 

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Again, taking that long term view,

 

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we've had for a long time now allocations to global

 

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credit as well as emerging market debt.

 

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From our perspective you just get broader diversification benefits

 

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from expanding the opportunity set by

 

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investing in areas outside the US.

 

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From our perspective we had increased

 

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at some point our allocation to global credit, this is

 

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going back a few years now, exactly to your point about the

 

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difference in terms of where the Europeans were

 

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in their cutting cycle relative to where the US had been

 

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so certainly had benefited from that.

 

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By and large we haven't seen significant

 

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opportunity yet within global credit so have not been

 

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increasing our allocation. Certainly, as things get

 

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more interesting perhaps that's some opportunity to add.

 

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I will say with respect to emerging market debt, EMD

 

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had a phenomenal year last year.

 

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They were the top performing sector within fixed income in

 

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double digits. That was a home run to

 

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have some of that exposure there.

 

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We had some really nice security selection opportunities

 

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within that sector that benefited our portfolios.

 

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There's probably not too many more gains to be taken.

 

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Their spreads have continued to move really tight.

 

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We're sort of back to this environment where we've got to be patient and

 

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really haven't seen an opportunity to add significantly there.

 

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It's always the thing that you don't know, it's the bump in the night that

 

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creates the catalyst, so it's impossible to say what it is but what would it

 

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be? What would be that catalyst?

 

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I wish I had that crystal ball, Pamela, it would make it easier.

 

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There's a couple other factors apart from

 

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this energy crisis that we're facing

 

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and sort of the follow through impacts to the consumer

 

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and growth expectations.

 

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Other areas we were even looking at before

 

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that, I think there's been concerns about what's

 

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happening in private credit. There's been a tremendous amount

 

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of headlines here in the US about certain products

 

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and investors being able to

 

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redeem from structures where perhaps they thought there was more liquidity

 

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than there was.

 

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We haven't seen really a lot of

 

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contagion from some of these headlines in private credit.

 

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It's still very much an institutional

 

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market.

 

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Leverage is still fairly low compared to previous

 

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credit cycles.

 

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From our perspective doesn't seem to be a

 

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huge source of volatility for us but certainly bears watching.

 

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The other area would be just the continued

 

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AI spend by the hyperscalers.

 

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We've seen them really tap the bond market in a significant

 

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way over the course of last year.

 

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We saw about 200 billion in investment grade corporate issuance

 

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related to that and expectations are going to be

 

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similar to that, if not higher, over the course of 2026.

 

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So far the market has really digested that supply

 

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but as net corporate issuance really continues to

 

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move higher at some point that could cause

 

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the market to blink, and maybe that's an opportunity.

 

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Hard to say at this point.

 

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I'll just say, Pamela, there's always the unknown unknowns.

 

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We think back to the last even six

 

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years or so, global pandemic, the

 

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2022 cycle that we talked about, regional banking crisis in

 

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in 2023, those were all periods where

 

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spreads moved significantly wider and I'd say nobody really

 

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had that on their bingo card, so to speak. You can't

 

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prepare for those but I think that's just where our process is,

 

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when spreads are tight you bring down risk, you have a lot of liquidity, and

 

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you're ready to take advantage of those opportunities.

 

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It's fascinating how you'll do that.

 

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If we could just go a little bit across the asset classes themselves.

 

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High yield has been a really interesting place to be.

 

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Tell us just a bit more about the safe haven.

 

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We sort of began the conversation with the

 

[00:21:45.937]

US bond market has always been the safe heaven but is there something more

 

[00:21:49.508]

electric about that now, or do you see that happening in the future?

 

[00:21:53.145]

Just the safety of it and where it goes,

 

[00:21:57.316]

and also providing some income. I mean, there's a nice coupon there

 

[00:22:01.320]

to take a look at for many investors who would be happy clipping that

 

[00:22:05.557]

rather than worrying about the risk.

 

[00:22:07.259]

I wonder if you can just sort of delve in there on the asset classes and

 

[00:22:12.064]

also the opportunity for income.

 

[00:22:17.102]

I think you hit it on the head just with

 

[00:22:21.073]

the point about yields continuing to be

 

[00:22:25.510]

elevated.

 

[00:22:27.579]

The yield on the Ag still probably in the 70th

 

[00:22:31.650]

percentile compared to the last 20 years so still

 

[00:22:36.054]

very high versus where we've been.

 

[00:22:41.760]

That is a nice opportunity to earn

 

[00:22:45.797]

that income. I also think from a total return perspective

 

[00:22:50.168]

that provides a lot of cushion.

 

[00:22:53.939]

Even as we see prices in bonds come down as part of

 

[00:22:58.009]

the sell-off you still have a lot that yield to

 

[00:23:02.214]

offset some of that.

 

[00:23:03.915]

That's why we have our own proprietary risk models where

 

[00:23:08.053]

we run 5,000 simulations every night.

 

[00:23:11.123]

It's much harder to generate...

 

[00:23:15.427]

That's a lot.

 

[00:23:16.194]

It is a lot. It's much harder to generate in those simulations a

 

[00:23:20.298]

negative return for the bond market.

 

[00:23:23.335]

There's just a lot more upside with that higher starting

 

[00:23:27.973]

yield.

 

[00:23:29.708]

What I would say is that view also extends across

 

[00:23:33.879]

asset classes. You mentioned high yield, for example,

 

[00:23:39.418]

high yield ...

 

[00:23:42.053]

spreads have moved wider but again we're not even at historical

 

[00:23:46.358]

medians or beyond that. On top of that right you

 

[00:23:50.595]

have that high starting yield so that's going to be a similar

 

[00:23:54.566]

cushion. The other way we think about high yield is that it's

 

[00:23:58.637]

got a shorter duration than investment grade corporate, that

 

[00:24:02.974]

shorter duration also means there's a little bit

 

[00:24:07.045]

more cushion from that perspective in

 

[00:24:11.082]

terms of even as you get some spread widening you

 

[00:24:15.320]

may not get the same level of price decline.

 

[00:24:17.756]

That's kind of why we think even in

 

[00:24:21.726]

periods like this high yield, leveraged loans, play

 

[00:24:26.364]

an important part of our diversified portfolios

 

[00:24:30.535]

where we can still get some some upside from those

 

[00:24:35.207]

sectors even despite a lot of this volatility.

 

[00:24:39.544]

Is it either fair, or I'll ask you to comment on, are you

 

[00:24:43.748]

staying away from areas that could be disrupted by AI,

 

[00:24:47.853]

essentially? It's sort of the software question, isn't it, but in terms

 

[00:24:52.023]

of lending and where you want to be exposed where are you

 

[00:24:56.228]

avoiding?

 

[00:24:59.664]

It's funny, actually, our high yield and our leveraged loan teams

 

[00:25:04.169]

had either been reducing a lot of their exposure to

 

[00:25:08.306]

software or underweight the sector relative

 

[00:25:12.377]

to their respective benchmarks.

 

[00:25:14.679]

That's actually helped during some of this sell-off.

 

[00:25:19.718]

I think that the story in software,

 

[00:25:24.756]

first of all, perhaps not all companies are equal.

 

[00:25:28.827]

There are many software companies that are still cash

 

[00:25:32.931]

flow positive. They may be fully integrated

 

[00:25:39.404]

across enterprises so much more sort of solid

 

[00:25:43.441]

fundamentals. That's where I do think that security

 

[00:25:47.479]

selection expertise is going to be really important as

 

[00:25:51.650]

you're looking at who may be winners and losers.

 

[00:25:54.486]

It doesn't mean you can avoid all the losers but

 

[00:25:58.623]

the goal is to have a higher batting average over

 

[00:26:03.295]

time. I think that's part of it.

 

[00:26:06.331]

I'll say just on the investment grade corporate side we've

 

[00:26:10.535]

been very selective.

 

[00:26:12.771]

We don't have a big allocation to technology broadly.

 

[00:26:17.208]

A lot of the AI issuance I mentioned has

 

[00:26:21.246]

come at very tight levels even inside the index.

 

[00:26:25.450]

A lot of these companies are single A or even double A.

 

[00:26:29.688]

It's just too rich for us to see much value there.

 

[00:26:34.192]

Again, perhaps there's an opportunity down the road but not anything we've

 

[00:26:38.697]

been adding in any big way.

 

[00:26:42.534]

Christine Thorpe, a calm within a storm it sounds like at

 

[00:26:46.605]

the end of this conversation. Is there anything you'd just like to leave with

 

[00:26:49.374]

investors as sort of a final thought or a message?

 

[00:26:55.947]

I think there's there's a lot of noise, there's a lot of headlines,

 

[00:27:00.151]

you've got to really look beyond them and just be thoughtful about

 

[00:27:04.155]

how you're making shifts in this type of an environment.

 

[00:27:08.026]

Again, for us it really matters how a lot of this is translating

 

[00:27:11.963]

into what we're seeing in the market so we're just trying to

 

[00:27:15.934]

lean into all the resources we we have.

 

[00:27:19.838]

We're talking to our energy analyst

 

[00:27:23.908]

who covers it from an equities perspective, our oil analyst that covers it

 

[00:27:27.879]

from fixed income, our inflation analyst.

 

[00:27:30.749]

We're just trying to bring all of our resources to bear as

 

[00:27:34.819]

we we navigate this.

 

[00:27:36.588]

Really, from our perspective, we think fixed income, still

 

[00:27:41.326]

attractive given all-in yield and we're just going to continue to

 

[00:27:45.330]

be patient and really wait for that better opportunity to add

 

[00:27:49.501]

risk.

 

[00:27:50.435]

Best way to end of Friday, speaking to you.

 

[00:27:52.771]

Thank you very much for your time and a good weekend ahead.

 

[00:27:56.675]

Christine Thorpe, thanks for joining us.

 

[00:27:58.143]

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[00:28:00.779]

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