Outerblue Talks Research - US fixed income - Early pain, later gain?

Disclaimer: This podcast is only for the attention of professional investors in the financial industry. Outerblue by Amundi. Welcome to Outerblue Talks Research, knowledge sharing on financial research.  

Swaha Pattanaik: US President Donald Trump has been back in the White House for less than two months, but packed a lot in during a short period of time. We've seen shifts in fiscal and economic policies, the approach to federal employment, tariffs, and something of a speed change when it comes to international diplomacy. Today, we're going to be discussing how all of these issues are affecting the outlook for the American economy and bond markets. And I can't think of two better colleagues to guide us through the flux and uncertainty than my guests today. First, it's a pleasure to introduce Jonathan Duensing. the head of fixed income and a portfolio manager at Amundi US. Welcome, Jon. Great to have you on the podcast. 

Jonathan Duensing: Thank you. Great to be on as well. 

Swaha Pattanaik: And also joining us this time from the UK, Mahmood Pradhan, head of global macro at the Amundi Investment Institute. Mahmood, lovely to speak to you again. 

Mahmood Pradhan: Thank you. And thank you for having me on. 

Swaha Pattanaik: So, Mahmood, Jon, I think I could probably spend the whole podcast just listing all the executive orders and policy announcements that we've had since Donald Trump's inauguration. For the sake of brevity and our audience's sort of sanity, Mahmood, let me, however, start off by asking you, what are the couple of measures that are having the biggest impact on your US economic forecasts and how are they affecting your views? 

Mahmood Pradhan: Okay, I'd say when I start, I think about the roadmap that was given to all of us during the election campaign. To turn to your question, I'd say the biggest two things, one is on tariffs, the actions of the US administration have been a lot more aggressive than what we expected from hearing the election campaign. Secondly, I think what has been a little bit disappointing is the one area where people were quite positive about the new administration was on the growth outlook and that was to do with deregulation in parts of the economy, and secondly the fiscal policy that would be strongly supportive, that has turned out. Both those areas. Aggressive tariffs, we didn't expect Canada, Mexico to be subject to 25 steel, aluminium 25 percent. Something's coming on Europe, autos, and then reciprocal tariffs we didn't expect. So it's a lot more aggressive. And secondly, on fiscal policy, I think the challenges are now coming to the fore. And I would point to two things. One is the drive to make the Federal government more efficient, the Department of Government Efficiency. Its challenge has become a lot more pronounced. Its ambitions were strong and the results so far are quite weak and I think on the budget front, we can come to that later, the negotiations are just starting. There will be some challenges to meet funding requirements with cuts in expenditure. I think the congressional discussions will be challenging. So those are the two I would say on my radar and quite a lot more aggressive than I had expected. 

Swaha Pattanaik: Thanks, Mahmood. Jon, what about the bond market and how are you seeing things in the US? 

Jonathan Duensing: Yeah, and I was just going to maybe augment a bit of what Mahmood said first in there. As we look at things and as they've unfolded here over the last couple of months, it's clearly a situation where we're going through a period in our minds of, let's say, the pain. And it's a lot of what's controlled through the executive branch. whether it's the immigration point Mahmood had made or whether it's tariffs, and even to a certain extent on the government efficiency side. Those are all things that are really more easily controlled through the executive branch and to a certain extent have created a level of pain, if you will, as it relates to uncertainty around the economy, uncertainty around government spending. And we've seen investors and markets react accordingly. It's really a question around when the gain will come and will we see the benefits from a smaller government footprint? Will we see the benefits from that fiscal policy that Mahmood had referenced maybe during the second half of the year? Will we see gains from deregulation? We anticipate that those are going to take some time and generally are probably going to be, along with the fiscal plan, something that requires some level of legislative action as well. So, more political capital needs to be spent and also more time to ultimately see some of the benefits of those. So, it's kind of early on, we're feeling the pain. And then the question is just, when do we really see and realize the gain? As it relates to the markets, specifically the U.S. fixed income markets, we could talk about treasury yields, since that's what everyone understandably focuses on these days. As far as most sensitive to for investors, that's been shifting somewhat. There's no doubt that early on in this year, the focus was much more around the possibility of a higher growth trajectory, the possibility of stickier inflation, and even some questions around U.S. debt sustainability on a long-term basis. For the most part, all three of those dynamics really drove yields higher. Since then, though, over the course of the last, let's call it a month, we've really seen a change in the narrative and also a change in what investors are focusing on as some of that softer economic data that we had seen that signaled maybe a diminished optimism out there with Trump coming into office has now translated through to signals from hard data that are showing somewhat of a pullback on the consumer side, as well as even lower activity on the business side here in the U.S. So as a result, the concerns have now much more focused on the growth side of the equation in the U.S., and that's a large part of the reason why we've seen this significant rally in interest rates across the yield curve, especially the longer end of the yield curve here over the last three, four weeks or so. It's really in reaction to this slower growth dynamic, which is the main area of sensitivity right now. 

Swaha Pattanaik: Thank you, Jon. So, I mean, you were mentioning the initial sort of positioning, which was looking for higher growth expectations, secure inflation. You've talked us through what the market is expecting now on sort of the economic activity front, which is a bit weaker. What about on stickier inflation? And is that also pain early and gain later when it comes to the bond market, given tariffs may push up prices in the short term? I'll throw that to either of you. 

Jonathan Duensing: Yeah, I'm happy to start. I still think that, you know, I think at this point, kind of most, you know, most people are aware of the fact that tariffs certainly provide kind of a one-off shock to prices. So, you know, we're in an environment where there's already sensitivity to goods, but mainly services prices and inflation remaining sticky and anything that's maybe going to amplify some of that stickiness or even push prices up higher in the near term. There's understandably some sensitivity to that, especially from the Fed standpoint, given that they're mostly focused on expectations and making sure that higher inflation expectations don't become embedded into the economy, consumers as well as businesses. So, you know, I think the near-term concern is really just, does that one-off shock, if we get it on the price side, ultimately from full tariff implementation, which, by the way, we don't know, we will see. It's kind of a, "every day seems to be a little bit different narrative", around what's going on the tariff front. But if we do see that price shock in there, it's going to be coming at a time where we're already witnessing some stickiness inflation. And we do think the Federal Reserve is going to certainly incorporate the potential for more elevated prices here over the near term into their calculus of how they think about monetary policy over the next three to six months. 

Mahmood Pradhan: Yeah, I think all I would add to that is the narrative on starting with what Jonathan's talking about in terms of yields, the reversal that we did not, was not consistent with the narrative. I think the growth outlook is more worrying. On inflation stickiness, I agree with what Jonathan is talking about. The framework we use in tariffs should have a change in the price level. Of course, in the short term, that also translates into higher inflation, but I think we can stay at the 2.53% range in the short term. So yes, stickiness makes the Fed pause a little bit. We in our internal forecast have stuck to expecting three cuts this year. The market expectations are obviously by definition a lot more volatile, but the markets are somewhere right now or somewhere around that level, three cuts. And that's because I think the growth outlook will be a lot weaker. And therefore, the Fed will be able to see this as a short-term thing. And we do not expect these tariffs to get entrenched in higher inflation, expectations for inflation. There is some significant difference between consumers' expectations of inflation, which are necessarily influenced by these tariffs, and business expectations of inflation, which are, I think, still more subdued. I would end with just one thing, and that's a market observation, which is when you look at the real rates implied in the TIPS market or the index-linked securities market, that has seen a very significant change. Just before the end of the year, last year in 2024, we were looking at something like 2.2% real rates expected, what markets were expecting, that has dropped to 1.8 plus. I think that is a summary statistic for how the market is seeing the growth outlook, which is a lot weaker. I should emphasize that we are not expecting a recession in the US. Our forecast has been for about just around the 2% handle, which is what potential growth in the US is, long-term potential. So we're going to come down from above potential, to potential. Consensus expectations have been a little bit more optimistic, and especially after the election results. And they, I think, are gradually kind of scaling down to coming nearer 2%. 

Swaha Pattanaik: Thank you, Mahmood. So you mentioned, Mahmood, fiscal policy earlier. So let's come back to that. There is obviously some physical stimulus in the pipeline and there may be cuts that perhaps a little harder to implement but will also come through. So how do you see this filtering through? Is it gain first in physical stimulus, and pain later? Or how do you see that timeline? 

Mahmood Pradhan: I'm a little bit cautious on interpreting or on expecting a huge contribution from these efforts to make government spending more efficient at the Federal level. I think at the Federal level, I look at things like employment costs. 4% of total public expenditure is accounted for by the wage bill at the Federal level. That's all Federal employees. Although I see a lot of cuts coming in Federal employment, I don't think that will make a very large contribution to fiscal consolidation or reining in expenditure. I think at some point they will have to look at Federal spending programs, rather than just employment levels, or cutting out some agencies and so on. And that's where I think the fiscal pain will register. That's necessarily slightly longer term. But in terms of reconciliation of what has already been given in terms of making the 2017 tax cuts permanent. Funding some of that, I think, will require changes in spending programs, and that will be contractionary. I don't see that as a stimulus. I mentioned and Jonathan also emphasized that that deregulation is the more positive aspect in terms of when one looks at growth outlook I think some of that is registering already in the way bank stocks are trading, because the financial sector will likely benefit from generally less regulation. but also in specifics, less requirement on capital adequacy, and capital levels which will benefit the financial sector. 

Swaha Pattanaik: Okay, Jon, let me turn to you. We're talking about some of the debt sustainability issues that have been ongoing. And you were talking about what the market's focusing on currently. How important is that size of the fiscal deficit? How much debt is being piled on? How important is that in investors' minds at the moment? 

Jonathan Duensing: I think it's always going to be something that's been relevant to kind of how investors are thinking about. You know, investing within the U.S. risk-free space. Really, I would say since October 2023, when the 10-year nominal Treasury yield almost reached 10%. And you saw adjustments from then-Treasurer Secretary Yellen as it related to auction schedules to dial back some of that coupon issuance in the future to alleviate some of the overhang of supply that maybe investors were getting more sensitive to. It's going to continue to be a consideration for investors because as it stands right now, the U.S. is on somewhat of an unsustainable path, if you will, in terms of debt relative to the size of the economy. A lot of that's just been a function of the massive deficit finance spending that's taken place really since COVID. But for right now, I think that's certainly taken a backseat to the more near term concerns as it relates to growth expectations. I would say to a lesser extent, inflation expectations. Right now, I think the bigger story is really what are we seeing as far as the growth outlook goes and how are investors reconciling the signals they're getting as far as near-term growth, maybe versus what those expectations were two months or so ago when there appeared to be much more optimism around, you know, the outcomes from the incoming Trump administration. 

Swaha Pattanaik: Thank you, Jon. And so, I mean, given what both of you have been saying, where do you see the best opportunities in U.S. fixed income at the moment. Jon? 

Jonathan Duensing: You know, for us, and this has been the theme over the last handful of months, you know, in general quality, Mahmoud had mentioned real rates kind of in the near 2% area as you move out to the intermediate to longer part of the yield curve. In a historical context, that's relatively elevated to think about being able to earn 2% plus after accounting for inflation. That's an area where I think history provides us somewhat of a guidance. But generally for us, quality has been an area where we have felt that there's some of the best value in there, just in part because investors are finally receiving reasonable income kind of within the risk-free market, four or five type of percent area, depending on where you are on the yield curve. Same thing can be said when you're looking even into the more of the traditional credit sectors, given how tight and compressed credit spreads are right now, somewhat of a function of, I think, optimism around economic growth continuing into the future here domestically. But then also, I think just all-in yields looking attractive for investors. So maybe some investors aren't discriminating around whether or not they're truly being paid enough for taking liquidity and credit risk premia. But when we look at these compressed credit spreads, it still feels that an up in quality bias is a reasonable place to allocate capital within the fixed income markets. If you want to go into the more yieldier segments of the marketplace, you can do that within the securitized credit space here in the U.S. where we think you still get a more reasonable liquidity risk premia. Even if you want to stay in higher quality, agency mortgage-backed securities are an area where valuations in terms of spread are much more attractive on a longer-term basis than the traditional credit sectors. And then also even in alternative spaces, such as insurance-linked securities, catastrophe bonds, things like that. Those are alternative sources of fixed income returns for investors where yield levels are still very elevated on a historical basis and in general relative to what we see in some of these other segments of the traditional, as well as even the private credit space here in the U.S. So generally up in quality. Enjoy the yield environment that we're in right now because it's one that investors haven't seen for 15 plus years. And certainly recognizing that you need to be much more selective these days just given how compressed spreads are in some segments of the marketplace. 

Swaha Pattanaik: Thank you, Jon. That's a really good overview. Let me close. We're nearly out of time. I wanted to close with a slightly sort of more general question. We feel at the moment that we're living through exceptional times, but maybe it always feels like that. You look back over time, I can think of the global financial crisis, the Eurozone crisis, the COVID crisis, the crises seem to come fast and furious these days in the last few decades. But does this one feel different to you? Is there any way that you are changing how you approach your job or decisions given the uncertainty and flux or is it actually the sort of pattern that you've seen before? Jon maybe I could start with you. 

Jonathan Duensing: Yeah, certainly. As someone who's lived through a number of business cycles, credit cycles, and liquidity cycles, you're right. I think what you alluded to is, to a certain extent, they all rhyme. But recognizing that markets do change and the flow of information changes. And as I think about just changes from where we were 20 to 25 years ago versus where we are right now. There's no doubt that we spend more time thinking about the global macroeconomic landscape because we recognize not only the interconnectedness of financial markets, but also just the interconnectedness of policy and the impact that that has on business activity, consumer activity. So to us, it's a recognition that you need to be aware, you need to have a very wide lens as it relates to the macroeconomic environment that we're investing in. I think the other thing that's been consistent throughout from our end here is the value of active management, especially within the fixed income marketplace, as we know that there are ways to generate durable excess returns or alpha through active management. And at the same time, making sure that you're flexible to be able to adjust the approach and the tools that you utilize. And certainly we're in an environment right now where I think all of those components are very relevant to how we think about continuing to deliver returns for our investors across all of our strategies. 

Swaha Pattanaik: Great. And Mahmood, let me throw to you, because you've had a ringside seat at some of the crises of past days. You used to work at the IMF before you joined Amundi and you were in the market before that. How does it feel to you as you're forecasting and your team is forecasting? 

Mahmood Pradhan: I think what's different about this one, and I'm just going to emphasize the difference, is the policy uncertainty. Other crises that I've seen at the policy level, there may be some inertia with policymakers trying to figure out the appropriate response, generating political consensus for responses and that sometimes takes time. Here I think the difference is the uncertainty of what exactly policy is going to be. Tariffs is one example where you see announcements and you ask will it actually be implemented or not. The particular aspect of that is as a forecasting team we have to sort of try and take out the noise. It's very difficult when the noise is coming directly from policymakers rather than forecast errors and things like that that we typically look at. So that's one, it's very different. It's a temptation and to resist the temptation to change forecasts too frequently. So that's a challenge. The second aspect which I'd say is many people in the markets, including ourselves, have for the last few years focused quite heavily on geopolitics. I would say that the more recent developments in terms of the U.S. stance on Russia-Ukraine relations with Europe, etc., has had a very, very direct impact on economic policy and markets. And what we're witnessing from yesterday to today in German bond markets, and the foreign exchange market, the Euro, I'd say this is the one time where we can actually put our finger on a geopolitical development has had a very significant impact on markets because it's made Germany significantly change its policy response, okay, in terms of more defense spending coming and so on. So I think this is the challenge and when I say, when I think about tariffs, and tariffs make, a U.S. interest, for example, in addressing whether trade deficits, unfair competition, etc., whichever way you like to put it, will have global repercussions, and it will lead to global fragmentation of trade, global and trade diversion or trade reduction. And I think this time, from a forecasting perspective, there's lots of parts of the world that we need to look at. Obviously, Europe, China, that what are the economic impacts and what's the economic consequences of higher tariffs from the US. Previous crises have not questioned the underlying structure of the global economy. Previous crises have been, if I can use in quotes the words, "more localized". And we focused then on what's that local policy response going to be. You know, my first crisis ever was when I was at the Bank of England and the UK fell out of the European exchange rate mechanism. That felt localized. It was big then. All crises are big. But this one feels genuinely global. 

Swaha Pattanaik: One question, though, on that, Mahmood. What is interesting, and I mentioned a few like the global financial crises or COVID. I mean, that was a global hit in the same way. I presume, Jon, Mahmood, this is a differentiated thing because what you were talking about with Germany, more spending would be good for. European growth and German growth, presumably as the biggest economy. So there is also a differentiated economic impact, I presume, that both of you would think. 

Mahmood Pradhan: I mean, I'd say on Germany, sorry, Jonathan, let me go first on this on a narrow point. On Germany, yes, it will affect our forecast. What we're now assessing is, when does this higher fiscal spending or higher defense spending materialize? In the short term, it's possible that A, we will see this defense spending essentially mean import more U.S. exports of defense military equipment because Europe will need to sort of raise its capacity to produce defense military equipment, which may take a little time. Secondly, just in terms of when the actual spending takes place, we would look more at 2026 than say a significant change in our forecast for 2025. So that's one aspect that it changes. But clearly, Swaha, your point is correct that we will need to revisit definitely our German medium-term forecast. This is a very big change. We're talking in the region of, you know, over the next three, four years, four or five percent of GDP. That's a very significant change. And then some other impacts and European initiatives on other Eurozone economies, EU economies. So in the medium term, definitely, you know, this will register. This changes the forecast. 

Jonathan Duensing: Yeah, I think what's also interesting about just this, you know, in the micro as it relates to Germany and the developments here is that in the recent past, what we've seen, particularly across Europe, has been we've had a movement at the government level really in response to an acute crisis that's taking place at the end. And I know that the Ukraine-Russia war is year three plus on that right now. But interestingly enough, this is more of a reaction of not a financial market-driven pressure or anything like that from politicians, but much more related to geopolitical. pressure. So it's somewhat of a unique situation. But ultimately, though, as one, as Mahmood had said, is going to require a recalibration now going forward as it relates to growth metrics, inflation metrics. And as a result, we're seeing asset markets reprice accordingly. 

Swaha Pattanaik: Absolutely. Jon, Mahmood, I could talk to you for such a long time, but I won't hold you up anymore. It's been great getting your insights. And thanks so much for taking the time to join us. 

Mahmood Pradhan: Thank you. Thanks very much. Thank you, John. Thanks, Swaha. 

Jonathan Duensing: Great. Thank you. Swaha Pattanaik And thank you for tuning in to this Amundi Research Podcast. 

Disclaimer:  Check out past episodes on our Research Center or on your preferred podcast platform. And see you next time. This podcast is only for the attention of professional investors, as defined in Directive 2014-65-EU. dated 15 May 2014, as amended from time to time on Markets and Financial Instruments, called MIFID II. Views are those of the author and not necessarily Amundi Asset Management SAS. They are subject to change and should not be relied upon as investment advice, as a security recommendation, or as an indication of trading for any Amundi products or any other security, fund units, or services. Past performance is not a guarantee or indicative of future results.