Cashing in on Fed ‘Insurance’ Rate Cuts
June 24, 2019
Expectations for easier Fed policy are boosting asset valuations because it is lowering the interest rate their cash flows are discounted at. In addition, since potential rate cuts from the Fed are viewed as ‘insurance’ to stave off an economic downturn, then asset values get an added boost because lower policy rates are reducing the risk of recession that would typically increase default risk and put those cash flows at risk. Lower rates and reducing recession risk explains much of the upward repricing of riskier assets.
Our Investment Strategy
Most of the investment returns attributed to long duration in our portfolios have already been recognized for this year. We believe ‘insurance’ rate cuts from the Fed are mostly priced in, and returns attribution in fixed income may be generated by carry and spread narrowing for the remainder of the year. Our focus remains on the real economy and the strength of the consumer in both investment grade and high yield credit. Financials, building materials, gaming and delevering themes in communications remain key sectors for us. Our largest exposure remains in non-agency mortgages and asset-backed securities due to strong credit fundamentals in select areas within this asset class.
What is the Bond Market Telling Us? Well...
It depends which bond market you are talking about. The U.S. Treasuries (UST) market is pricing a recession in 12-months. Credit/high yield is pricing an extension of the economic expansion (low recession risk/low default risk). The bond market indicates that lower UST rates are increasing the valuations of riskier assets.
Where will UST yields level out?
If we take at face value the market expectation for rate cuts close to 100 basis points, then we believe the UST 2-year yield could fall to within a range of 1.50% - 1.75%. The yield curve should have some slope if these cuts serve as an insurance policy against rising recession risks, 2s10s 25-50 basis points. This leaves the UST 10-year yield in a range of 1.75% - 2.25%.
We believe these levels are fair and reasonable based on what we know right now. Lower yield expectations require a more negative economic outlook than is currently priced, and vice versa for higher yields.
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks.
Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the Portfolio may generate less income. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities ("junk bonds") are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
Please consider the investment objective, risks, charges and expenses of the fund carefully before investing. The prospectus contains this and other information about the fund. To obtain a prospectus, download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.