Complex Fixed-Income Picture May Hide ‘Upside Surprise’

Following the Federal Reserve’s decision this week to hold off at least a little longer on its next rate hike, one Prudential fixed-income leader anticipates a volatile but fundamentally strong time ahead for bonds. 

During a recent call with financial industry reporters, Robert Tipp, chief investment strategist and a manager on the Prudential Total Return Bond Fund, shared his outlook and Prudential Fixed Income’s current stance on the fixed-income markets, following the release of the firm’s wider 2016 market outlook.

While not unbridled in his optimism, Tipp is clearly enthusiastic about prospects for the bond markets in the coming months, especially for those investors who are selective about their risk-taking and identify with conviction where opportunity lies.

“Admittedly this seems like perhaps an inauspicious time for a conversation about opportunity in the bond markets,” Tipp said in opening the call. “We are only one rate hike into the tightening cycle and the 10-year treasury note is right at 2%. However, as we all know, things in the investment world are not always what they appear to be on the surface.”

All things considered, from global equity market volatility to the wide moves in European and Asian economies towards more quantitative easing, Tipp says he strongly believes there is a lot of opportunity in the bond markets, “not just tactical but strategic too,” especially for long-term investors. When it comes to retirement plans and individual investors, Tipp suggested interest is blooming, and rightly so, in diversified/packaged approaches to higher quality fixed-income securities.

How could this outlook and enthusiasm coincide with what, by some measures, looks like a pretty weak outlook for bonds and fixed-income? Especially given the demographic trends of an aging global investing population that will dampen economic growth and put a lasting drag on rates? “It has to do with the outlook of the U.S. Federal Reserve, global government-driven interest rates and what may happen next with corporate spreads,” Tipp suggested.

NEXT: What the Fed is (really) saying

Looking to the Fed, Tipp believes the supervisory and regulatory agency has done a solid job, especially in recent weeks and months, of “threading the needle of optimism and caution.” Important to note from this week’s Federal Open Market Committee meeting, he said, is that “they removed the ‘confidence’ wording around inflation raising up to their longstanding 2% target in the near to mid-term future. I took this to be an attempt to indicate ‘patience’ about raising rates without wanting to dampen the underlying outlook for the economy itself.”

The committee also used language on “financial conditions tightening,” Tipp noted, “but in this case they were putting less emphasis on the downside risk to the economy. So, I feel that they came out of the meeting delaying the next rate hike but without damaging their perceived outlook on the economy. It was a successful move, I think, from that perspective.

“They clearly believe they should be hiking rates, but they also believe they don’t need to do it very quickly,” Tipp explained. “All previous cycles have seen one raise per meeting, pushing rates fairly quickly up beyond 1% or 2%, but that cycle has already been broken this time around. They’re going to be raising rates very slowly and methodically.” Asked by one reporter where U.S. rates my be by late 2016, Tipp predicted the Fed's target would at a maximum be 1% to 1.125%, “but it's likely to be even lower given the cautious messaging.” 

Tipp went on to describe this as a “shallow tightening cycle,”  driven more by the Fed’s precautionary and preemptive motivations rather than fear of any looming bubble crisis, a la 2008. “They want to move on rates early and very slowly so they don’t need to chase rates later and risk damaging economic performance through rapid rate hikes,” he said. “They’d much rather just have interest rates higher to begin with so they can cut should an unanticipated emergency emerge.”

NEXT: Global fixed-income trends are diverging  

The U.S. remains one of the strongest economies in the world right now, Tipp continued, “and we’re not really seeing strong signs of overheating, so that is meaningful.”

Looking internationally, especially to Asian markets and the Eurozone, there is essentially the opposite trend happening.

Looking to the main markets, Japan for example, they are below 1% on 20-year central government debt,” Tipp says, predicting rates will actually fall further, potentially bringing tactical opportunities. “They need to improve the structural side in Japan, which they are doing, but they also needed lower interest rates to stimulate growth.

Even more important than more easing in Japan, the Eurozone is the other big elephant in terms of driving overall economic conditions,” Tipp explained. “In Europe, people are essentially paying for the storage of their money in fixed-income right now, effectively, due to record low interest rates and even negative rates in some regions. But their next move, if you can believe it, is more ease, lower rates and more bond purchases.”

Start reading between the lines here and one can see that the Eurozone and most Asian economies are a long way away from a rate hike cycle, Tipp concluded. “It’s going to take them a long time to taper and to pave the way to go from negative interest rates to positive rates. They won’t remain rock bottom through 2016, but they are likely to stay below 1% for a considerable time.”

Closing the call, Tipp said Prudential Fixed Income is confident that in 2016, “fixed income is really going to surprise. We have had a pattern where we have a bad year for bonds followed by a good year for bonds for some time now. Last year, I would argue, was the bad year, and now we’re moving into what should be a better performing period.”