A new paradigm for fixed income: Tariffs, Treasurys, and Trump

This session is with Andrzej Skiba, head of Blue Bay U. S. Fixed Income, RBC Global Asset Management, U. S. Inc. Thank you for joining us, Andrzej, and I'll turn it over to you to get started.

Hello, and thank you for the opportunity to speak to you all. Well, today we wanted to cover, three topics to do with fixed income markets in 2025, and, specifically, about the impact of the Incoming Trump administration, on, our investment universe.

So firstly, we would like to cover topics such as us inflation growth and the fed, in Trump 2. 0 era. Secondly, how, we view these implications. impacting, fixed income securities in 2025. And finally, the third point, looking at what kind of an investment approach could, this environment lend itself

So first let's start, talking about inflation and the Fed. Well, from our perspective, lower taxes, major immigration curbs and a potential trade escalation could all be, quite inflationary, particularly in the case of a trade escalation. If the new incoming administration goes for a full blown, 10 percent set of tariffs on majority of trade partners and majority of goods and even further escalation with China that could increase headline inflation by up to 1 percent point according to our analysis.

Well, 1 percent does not sound like a lot, but from a Federal Reserve's perspective, such an increase in inflation can make all the [00:02:00] difference between being able to cut rates and not. So, as we're looking at, particular details regarding, expected increasing tariffs. it's worth noting that there is a variety of voices within the administration on this topic. The new commerce secretary, Lutnick, was actually speaking in somewhat conciliatory way in, over the recent days, however. We also have perspectives from other administration members, that point to a much more aggressive, trade policy ahead. And looking back at the presidential campaign, president Trump was, very vocal in pretty much every of his stump speeches about the need for aggressive tariffs and how those could benefit us economy so whatever your perspective whether you agree with that approach from economic theory perspective or not the fact of the matter is president trump absolutely believes that this is something that would be beneficial to the us so with that in mind.

Our expectation is actually, that the package of, tariff measures could indeed be quite aggressive because, from Trump's perspective, there's limited downside in diluting these, proposals. One thing that is worth highlighting is that in any case, as we, finish, this year and look towards 2025, the market is pricing between two to three cuts, in 2025.

So, According to inflationary impact of all of the factors that we mentioned earlier, lower taxes, immigration curbs, and trade escalation risk, we see a potential for fewer cuts than currently priced in happening. And if a full blown trade escalation is indeed the scenario we live through in 2025, Then in our opinion, it is very much a possibility that Fed will not be in a position to cut rates at all.

So at the minimum we expect a pause from the Fed early in 2025 as it assesses policy implications of the new administration. But clearly there is a risk to fewer cuts than the market is pricing in at this juncture. From a growth perspective, we see actually a slightly brighter picture, compared to, the case for inflation.

Lower taxes and weakened regulation should support a brighter outlook for the U. S. economy. There is a reason why stocks rallied, quite hard in the aftermath of the election. That was largely to do with the expectations of lower taxes, less regulation and more M& A activity ahead. Well, we also note that while all these factors are positive, you also have to take into account the fact that consumer would be hurt by higher prices and income.

If the trade escalation, manifests itself as much as we expect, that will be a drug to growth, offsetting some of the benefits that we've just highlighted, but net net, we do easily see a scenario where us growth exceptionalism continues. And even if we, see some slowdown to the rate of growth, in the U.S. still we expect U. S. to stand out and look favorably, compared to other major economies, in the world. it's worth highlighting that we do not see, a recession as a base case scenario for, 2025. And, at worst, we expect a growth slowdown from current levels rather than something, particularly ominous.

And that is actually important to remember because that provides, some protection for asset prices as we navigate, through 2025. Then moving to the second question, and, looking at various implications of this new administration of the backdrop that we've just described for inflation and growth, for fixed income assets.

And first, let's start with, U. S. Treasuries. And there, even though we have seen already quite a sell off, in treasury prices and higher yields in recent months, We could easily see some further downside risk from our perspective, a loose fiscal policy, something that we very much expect to be the case in this new administration, potentially calls for 30 year treasuries, moving higher in yield, even possibly to 5%.

We do note that markets like swap spreads, indicate that investors are demanding more compensation further out the curve, to put their cash to work. And that is the reason why we do expect the pressure on Longer duration securities in this, high deficit environment where treasury issuance, will be aggressive, throughout the year.

Well, that kind of an environment where markets reflecting on the fiscal deficit outlook, Is calling for steeper curves, as I mentioned, probably more pressure on 30 year securities than on the front end of the curve. However, this assumes that you will not have an aggressive trade escalation manifesting itself.

And as we've mentioned, we do see a good possibility of that scenario actually playing out. And with that in mind, if the market has, to reduce the amount of rate cuts, it's pricing that will happen mainly at the front end of the curve. So you can easily see a world where initially steeper curves are followed by flatter curves as the front end of the curve adjusts to the severity of the trade escalation ahead.

At the same time, as we're looking at the outlook for treasury prices, we hear many investors concerned about more ominous scenarios rather than just some price adjustments at the back end or the front end of the curve and, questions about sustainability of, US, debt markets, you know, questions about bond vigilantes potentially coming into the US fixed income, space from our perspective.

That is quite unlikely. It's true that, as, treasury issuance will be particularly heavy, over the course of the next year, and we see some pressure on prices and demand from investors for more compensation to put their cash to work, that can create a volatility within treasury markets. But for as long as us is seen as reserve currency for the world.

And as long as us growth does not collapse, neither of which are possibilities we see in the near term, we do not think this translates into an overall strike from investors and bond vigilantes manifesting themselves. the way we would describe that is that, you are likely to see a variety of treasury auctions, individual auctions where, we will see fat tails and, weaker outcome of these, auctions. But those will represent more like tremors rather than an earthquake, that would upset the overall fixed income market. So from our perspective, yes, there will be volatility. We could see some weaker auctions, but, as yields move higher, We expect enough of a demand pool between households, banks and foreign investors to absorb that issuance, rather than something more dramatic happening, within, the treasury, universe, looking at the credit markets we also want to highlight a few dynamics, at play. The first one is a simple fact that from a spread perspective, it's very difficult to argue that investors are generously compensated for risk. As we look across different markets in investment grade or high yield, we are trading in some cases at multi year spread tides, which indicates more limited room to, for spreads to, tighten from here.

We do note that there are pockets of value across all of these markets. but, we expect that there will be fewer and fewer as the year progresses. Having said that, to us, this is a reflection of a market that anticipates, a lot of rate cuts ahead and has positioned itself, for such an outcome.

As investors might have to, factor in higher inflation and reduce likelihood of Fed rate cuts, we do believe that that will, create a period of volatility. Where a lot of money that has moved to the market. To be invested further out the curve in anticipation of aggressive rate cuts goes back to cash or short duration securities, and that could be quite disruptive if we think about it in the last few years, we've seen hundreds of billions of dollars moving into intermediate core, so longer duration products, and some of that money might want to go back to cash as you can imagine, such magnitude of reallocation could lead spreads wider.

So from our perspective, we see a strong merit in, reducing exposure to longer duration securities, in portfolios and focusing on shorter duration assets, be it in the corporate credit market or securitized markets. those benefit strongly from, Much better break even characteristics. So even if yields move higher, even if spreads move wider, during any dislocation, your total return outlook is much more shielded, in short duration securities that are less sensitive to fluctuations in the market, where you benefit from the carry of the asset class rather than take aggressive views on spread tightening or rate rally itself. in this way, we would hope to protect portfolios from that potential dislocation and, sit out, this period waiting for further clarity, on the policy front. Eventually we do believe that once investors have clarity, Both in terms of, trade policy, so the extent to which we will see a trade escalation, but also Fed's response to the new policy mix under the Trump administration, we do believe that buying in spread products will return.

There are so many investors both in the U. S. and globally that would love an opportunity to gain exposure to U. S. assets at higher yields. So once that policy clarity is gained, we absolutely believe that those yield sensitive buyers will re engage with fixed income markets and that will warrant return to holding substantial exposure to longer duration securities.

But for the time being. We believe that profit taking after a period of very strong spread performance and caution over the months to come warrant moving towards shorter duration securities. If we see no rate cuts ahead, clearly that could accelerate the period of risk transfer from longer duration securities towards cash, or shorter duration alternatives. If the trade outcome is more benign, we think, there will be less of a need for any volatile readjustment within the markets. One way, one way or another, we do highlight that this is not a call to exit fixed income exposures. This is a call to rebalance fixed income exposures towards short duration securities, where yields are already quite attractive by historical standards and you can sit out the volatility.

Finally, we wanted to highlight some of the investment approaches that in our opinion, could work well in this, 2025 trading environment. Well, the first point, is that investors really need to be nimble. you can expect more periods of volatility, more periods of, dislocation than was the case in recent years, because the market just has to grapple with a new policy mix and response from the fed.

As growth fluctuates throughout the year, there's also a risk of investors extrapolating any weaker periods of data to project something more ominous, like a recession. We did mention, however, recession is not our base case scenario. We think U. S. economy is in too good a shape to see that. However, you have to be prepared for periods of volatility When data gets slower and stand ready to take advantage of those dislocations as they arise.

The other aspect that we would want to highlight is that this changing environment where, you need to be prepared as an investor to change positioning to reflect evolving, changing conditions and valuations in a forceful manner is great from a, from a active investment perspective. We've always believed that for active investors, in order to generate meaningful alpha, a volatility is one of the two key needed components.

The other one, of course, being manager skill. So from our perspective, looking into 2025, it will be a great test for active strategies in terms of delivering On the promises they made to clients and we look forward to taking advantage of greater volatility, dispersion of assets and dislocations to buy assets at much more attractive valuations as the year progresses.

Wonderful. Thank you for your insights, Andrzej. We have received quite a few questions from our audience. As a reminder, if you have a question and have not yet submitted it, you can do so by typing it into the Q and a box. If your question is not addressed on today's event, you will receive a response back directly.

Let's start with this first question. An advisor is asking, do you see an environment where fixed income performance Could be as adversely impacted as, as the bear market we saw in 2022?

That's actually a great question. And, it's actually very important to recognize that we see, even in more negative scenarios, a very different environment compared to 2022.

The problem in 2022, was twofold. The first one was that the, treasury yields and generally yields, but in fixed income were quite low by historical standards. So you had very little protection in terms of carry in terms of the yield of the asset class that you get paid just by holding fixed income assets.

And, therefore. Very limited ability to absorb any shocks, whether it's high yields or wider spreads, therefore, and therefore we've seen double digit negative, returns within the asset class, something that upset a lot of investors and fixed income definitely did not perform its role in your balance securities portfolio.

Well, this time it's quite different because the starting yield of the asset class is significantly higher. So depending whether you're looking at investment grade or high yield, we're talking about mid high single digit yields that will protect you from a rise in yields and wider spreads. To a large extent.

So from our perspective, even if you look at the market, there's probably, the most sensitive to what is happening in the macro markets and that's investment grade. if you assume no rate cuts ahead and treasury yields moving higher to, to the extent that we have highlighted, and maybe even some spread widening alongside that, that would, in our opinion, lead to low, single digit.

And the outcome that we've seen in 2022 is just not the scenario that is possible when yields are already so much higher than was the case back then.

Thank you. The next question asks, is there a place you would recommend investors to allocate within fixed income to write out a potential trade war?

Well, From overall portfolio perspective, as we mentioned, we do like short duration securities because they are less volatile and less susceptible, to, higher yields or wider spreads in the market in terms of your total returns. So whether you're looking at corporate credit or whether you're looking at, securitized, credit, so for example, short duration, ABS, or, MBS opportunities, We think those are really good places to hide out for the time being.

Also, it's worth highlighting that in this higher for longer environment, because if trade war is, of the more aggressive variety, that means, probably fewer cuts, or maybe even no 2025 and that world floating assets should do well. So, assuming careful credit selection, we think that the leveraged loan, broadly syndicated market is a place that, could see, an increase in demand.

We, are not as positive on, on direct lending. Because in that space, within the direct lending private credit universe, issuers are facing much higher funding costs and see much less flexibility in responding to weaker economic conditions. so we much prefer the leveraged loan broadly syndicated universe in that scenario.

Finally, It's also, worth highlighting that across our investment universe, we would avoid issuers that would be the most directly impacted by that trade escalation. So when you're looking at, retailers, especially discretionary retailers, when you looking at autos and auto parts, those are some of the candidates to be avoided or at least.

When you selecting those sectors, making sure that you already paid more in spread compensation terms than, for, less impacted alternatives. So, generally from a broader portfolio perspective, short duration, investment grade assets, leverage loans, within, that universe and avoiding those sectors that are most directly impacted by a trade escalation.

Thank you. And an advisor is noting credit spreads are tight. How do you think about adding spread duration versus interest rate duration to portfolios in this environment?

So the two decisions are different in our view. So in terms of adding to interest rate duration, as I highlighted earlier, we don't think this is the time to do it until you gain policy clarity. If, The trade policy will be more benign than what we heard during the election campaign. Then absolutely, it will be a time to re engage with fixed income further out the curve because while inflationary because of the immigration policy.

Or, or lower taxes, such increase in inflation is unlikely to prevent the Fed from cutting rates. But we do think that having a very benign trade outcome is relatively unlikely. So In that, respect, we would wait for the market to fully reflect on the details of that new trade policy and to hear from the Fed about how much it limits their ability to cut rates in 2025 before re engaging from interest rate duration perspective with the market.

In the meantime, we do believe that there is validity in the curve steepening trades. IE, being underweight, longer duration assets and favoring shorter duration assets within the treasury curve, as the market is so focused on the weaker fiscal dynamic. But as we highlighted earlier, that steepening focus could easily change, towards, bear flattening, context.

If indeed we go for an aggressive trade policy ahead. And market needs to price out, rate cuts. So for the time being, we would be light in terms of treasury exposure. and would only go more aggressively bullish on the space. Once policy clarity is gained across our markets from a spread perspective the picture is a bit different because, Yes, it's true that generic spreads are not particularly attractive across various manifestations of fixed income after the rally we've seen in, recent times. Having said that, we like the spreads at which shorter duration securities trade. we find that credit curves are pretty flat.

So when you're buying 10 or 30 year bonds, Let's take investment grade market as an example. Most of these securities trade and spreads between a hundred to 130 basis points, but then you can buy plenty of short duration bonds still within investment grade that trade at spreads anywhere between 80 to a hundred.

So to us, you actually not giving up too much in spreads by moving towards that shorter duration focus. And we see good value for those assets, at, historically elevated, yields as, we see some potential volatility in 2025 and market gets done policy clarity that we referred to a few times during this recording, we would absolutely, want to take advantage of any spread dislocations.

And when that policy clarity is gained, Again, by, 10, 30 assets, at much better entry points than is currently the case.

And I believe we have time for one final question in portfolios with risk budget that can be spent on foreign domicile risk. Do you see this as an opportunity to add to those positions, reduce or neither?

That's a really interesting question because, when we're looking at, the global economic backdrop, clearly us, looks so much stronger than most of the other regions, whether you're looking at Europe teetering on the brink of a recession, and with some countries like Germany suffering, particularly, during this time or China, where we've seen very disappointing economic data and, all the recent announcements regarding potential stimulus, bring some hope. however, market is also a bit skeptical about them, being successful. U. S. really stands out from, the rest of our investment universe. Having said that, We, do acknowledge that, non U. S. issuers coming to the dollar market, looking to issue, in the U. S. market often, issue with extra spread compensation on the table. The same applies for corporate issuers. The same applies for sovereign issuers. So, while we would prefer, To, have a bias towards us securities, in our portfolios, we also see room, for adding some foreign holdings in dollar denominated context at more attractive spread, entry points, especially for those issuers that are less growth sensitive, that will be less impacted by global trade escalation.

Wonderful. Well, thank you again for such an informative discussion, Andrzej. If you would like to continue the conversation on the topics discussed today, you can note the preference via the survey at the bottom of the console. Thank you to our audience for joining us on this session.