It’s tough these days for investors who don’t believe the US economy is headed for disaster. Buyers in the market for the safest American assets aren’t exactly spoiled for choice.
Bets on extensive Federal Reserve policy easing have made short-dated Treasuries more expensive, and perhaps painfully so if global risks disperse.
If trade tensions subside and inflation data pick up, a couple of Fed interest-rate cuts may be sufficient to keep the US economy humming along, and allow short-dated yields to rise.
That’s Jerome Schneider’s expectation. The head of Pacific Investment Management Co’s short-term portfolios reckons disappointment can’t be too far off for traders who are backing close to a full percentage point of easing over the next 12 months.
Against this backdrop, he sees a rare moment for assets that typically don’t do well when interest rates are falling: floating-rate notes.
“Quite honestly, very few people would suggest owning floating-rate notes in a declining rate environment, so this is a unique situation,” Schneider said.
FRNs tend to be more popular when market yields climb, as their coupon adjusts in line with shifts in market-driven benchmarks such as the London interbank offered rate or Treasury bills.
As a result, floaters tend to go down in price as overall market yields fall.
For Pimco’s Schneider, high-quality notes at the short end of government and corporate debt markets have been beaten down to attractive levels, given what he sees as outsized expectations for Fed cuts.
His is a contrarian call, if recent activity in FRN exchange-traded funds is any guide. Trading volume spiked last week in the iShares Floating Rate Bond ETF – the largest in this asset class – suggesting a possible $200mn outflow.
That move came as comments from two senior Fed officials spurred the market to price in a larger-than-usual interest-rate cut this month, though traders have since trimmed these positions. Schneider also oversees an actively managed ETF for Pimco that invests in short-maturity debt.
Even with that slight retreat, current market pricing “seems a little bit overdone unless you get into the framework that we are truly headed for a recessionary environment,” said Schneider, noting that his firm puts odds of that at no more than 25% for the coming year.
A back-of-the-envelope comparison across high-quality, short-dated securities suggests that FRNs have trailed other notes this year, but not by much. Securities to be repaid in one to three years within a Bloomberg Barclays index of US floating-rate debt have returned around 2.4% so far in 2019, according to data compiled by Bloomberg.
That compares with 2.7% on similar-maturity notes across a broader aggregate index of US debt.
In the months to come, investors in the front end of the curve who are focused on capital preservation and income “might not necessarily be wanting to take as much interest-rate exposure as the market is suggesting,” Schneider said.
Still, investors looking for ways to push back on the market’s biggest doves are understandably wary of simply putting money on a reversal in short-dated rates. Setbacks in the Treasury market’s rally this year have met with fresh bursts of buying.
That demand has pushed the benchmark two-year Treasury yield down to around 1.83%, almost 80 basis points lower than its January high and more than half a percentage point below the current fed funds rate.
Aside from FRNs, Schneider also favours some trades that are more widely embraced in the market, such as backing a yield steeper curve and favouring Treasury Inflation-Protected Securities. “Unless you believe the Fed is going to be unsuccessful – wildly unsuccessful – the focus will be on inflationary pressures gradually building over the next year,” he said.
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