FidelityConnects: The Fed Decides: What it means for bond investors

[00:05:29] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. The Federal Reserve has held its key interest rate unchanged. With uncertainty rising around growth, inflation and geopolitics our next guest suggests this may be the kind of backdrop where US Treasuries regain attention as a potential safe haven within fixed income. With credit spreads beginning to shift this only reinforces the value of holding quality and maintaining flexibility. How should investors think about positioning fixed-income portfolios in this environment, and what could increased volatility mean for the way investors approach Treasuries? Joining us here today to take us through her thoughts on the latest rate decision and its potential implications for bonds and beyond is institutional portfolio manager, Christine Thorpe. Hello, Christine, very nice to see you. How are you?

[00:06:23] Christine Thorpe: Hi, Pamela. I'm well, thanks for having me.

[00:06:24] Pamela Ritchie: We're delighted to have you join us, and we'll invite everyone joining you here today to send questions in over the next 30 minutes or so, we can put those to Christine. You, at Fidelity, are very much attuned to a longer term story. That said, what's going on in the shorter term story is just mind boggling and the volatility across asset classes has been enormous. I wonder if you can set us straight on just how quickly you've had to react to everything that's going on right now and how different that is from the beginning of the year.

[00:07:01] Christine Thorpe: I think you're right, Pamela, to dial in on that long term perspective because that's certainly how we think about investing our clients' assets. Coming into this year, and this has been pretty consistent for a while now, we really had taken risk down across our portfolios. I'd say that really was based on the fact that while the fundamentals have actually been decent valuations have been incredibly tight or rich. Across our suite of fixed income portfolios that's really meant we've had a lot of dry powder in terms of US Treasuries within our portfolios. Really, our thought has been Treasuries have been really attractive from a risk-reward perspective and at the same time, like I said, with credit spreads being so tight you just weren't getting really compensated to take on a lot of risk. I'll say most of the yield in credit was actually coming from rates. That's felt to us like a pretty good trade-off, take down the credit risk, have a lot of dry powder.

[00:08:21] Certainly still risk-on in our portfolios. We've been outyielding the benchmark. It's not to say that we don't have any risk but I would just characterize it as being towards the low end of the spectrum relative to where we've been historically. Even with all of the news flow and the headlines we're seeing, Pamela, there actually haven't been a lot of opportunities to deploy that dry powder. Credit spreads have been fairly well behaved, leaking a little bit wider in the midst of this volatility but not a huge opportunity to go out and add a lot of risk, so continuing to really lean into the same themes as where we started this year, patience being, I would say, our top idea and also emphasizing the importance of diversification.

[00:09:15] Pamela Ritchie: That's very comforting in the midst of what can be a little bit like watching a tennis match going back and forth between so many different voices and very serious events going on in the world to know that you have sort of a consistent view on where the value of the market is and that's where you're staying and sort of at the ready. Enter the decision from the Fed which was made along with all kinds of other fundamental pieces but, obviously, trying to deal with the fact that the price of oil has spiralled and gone up so the inflation question very much comes back to the fore. Just give us your thoughts on maybe the decision. I think most people are pretty acquainted with the decision at this point but really sort of what it means, I guess, a bit longer term for investors.

[00:10:01] Christine Thorpe: You're right, the market was pricing that the Fed would be on hold so no surprise from that perspective coming out of the meeting this week. If we look at the projections the Fed put forth they are still holding to potentially one cut for the remainder of this year and then perhaps another cut in 2027. Growth was slightly upgraded but I'll say Chairman Powell is pretty clear in cautioning investors to perhaps not pay too much attention to the projections they put out just given the degree of uncertainty there is in the market. I would say Chairman Powell's comments and the way the market read the FOMC statement was definitely leaning towards the more hawkish side of things. He certainly was leaning into the concerns around inflation coming on this oil price increase. The market certainly was in line with that. Even today we're continuing to see expectations around the Fed cutting this year continue to get priced out.

[00:11:28] There's clearly this narrative of oil is going to continue to play havoc on inflation expectations so we should be prepared for the Fed to be on hold for a while longer. I'd also say, interestingly, Chairman Powell also alluded to the fact that ... or I should say explicit about the fact that he plans to stay in his seat until the Kevin Warsh nomination and confirmation process has concluded. It's still an open question as to when that will happen. In addition to that he's going to stay in his seat on the Board until the investigation against him has been fully concluded. I think, certainly, giving the administration a lot to think about in terms of whether it makes sense to sort of move the investigation, conclude it, so that they can continue to have perhaps a board that's more friendly to the administration's desire to get rates lower.

[00:12:42] Pamela Ritchie: Do you think that provides stability to the market for the Chairman to be explicit about he's staying until this conclusion? Is it useful in either direction or is it sort of a nothing in a way?

[00:13:00] Christine Thorpe: I think we've had this narrative out there, the questions around how independent is the Fed going to be? For all that debate we haven't really seen that bleed into longer term rate expectations. Longer term rates, sort of putting aside some of the more recent activity, were pretty well behaved so I think the market was really sort of feeling like, hey, the Fed is going to maintain its independence, that's obviously incredibly important, but I think it does perhaps create an environment where the Fed could continue to be a little bit more hawkish as they place more of an emphasis on the inflation side of story rather than the labour market. I think it's early days but certainly important to see Chairman Powell putting that stake in the ground.

[00:13:59] Pamela Ritchie: It's so important to get your thoughts on that because you're watching where markets are telling you things are going and a lot of us get stuck in the headlines so it's just really important to kind of hear what the market is quieting there. In terms of analogies to past situations, 2022 is not so far in the past and it was a situation where inflation essentially meant that equities and bonds went down together. Some will say there's some muscle memory, there's some fear that that could happen again when you see inflation for reasons of oil or other reasons come on back. How do you address that?

[00:14:39] Christine Thorpe: You're right, we're back to that sort of positive correlation that we saw back in 2022. We're continuing to see that play out here. As we think back to the 2022 period, the rise in oil prices coming out of the Russian invasion into Ukraine, the inflationary backdrop, I would say, was a little bit different at that point. This is when we were starting to hit 9% inflation. We've certainly come off those highs. I think no question inflation has continued to stay stickier than the Fed would like as we're still well above the 2% target. I would draw a distinction between the inflation backdrop back then versus where we are today. Now, other sort of interesting points, I would say in 2022 the consumer was still riding all the fiscal stimulus coming out of the COVID period so they had a decent amount of cushion to help with the oil prices. The parallel there I would draw is the consumer does have some support coming through the tax legislation and the One Big Beautiful Bill. I think there is still a question of how much of this increase in prices at the gas pump, what is the ultimate impact going to be to the US consumer with that sort of fiscal backdrop. Certainly, I would say that the longer that we are in this elevated oil price environment and the degree to which the prices increase, that's going to have significant impacts for potentially leading us to more of a slowdown in the US economy. That comes back to the Fed and sort of their path forward if we get more into that recessionary type environment, that's when we can get back to perhaps the Fed resuming the cutting cycle.

[00:17:04] Pamela Ritchie: The big story on the fiscal side, as you say, is the components of the One Big Beautiful Bill that are sort of the refunds that are meant to come through the spring period and to what extent. This comes to that question of whether the oil price shock for US consumers is offset by exactly what you said, the tax refunds, and if that can allow what's going on now to be just called transitory. Could you make a call one way or the other on that? Would you dare to? I know it's hard to make a call.

[00:17:37] Christine Thorpe: You're right, and that was sort of the rhetoric from the Fed. We have to bear watching. I think some of the work that they've done has pointed to perhaps these higher oil prices don't necessarily have a huge impact on core goods when we think about it from that perspective. Again, I think that's where really the duration and the level of oil prices just on the broader impact is going to be really important from that perspective.

[00:18:18] Pamela Ritchie: I might just add to that the position from sort of a regional, global basis that perhaps the American consumer, because of the tax refunds and dealing with oil at the same time, is it in a better position because it has this fiscal backdrop, this sort of wind at its back on some level to afford what's going on, and does that change the story and make a US exceptionalism story kind of creep back in that particular way. What do you say to that?

[00:18:51] Christine Thorpe: I don't know if anyone is exceptional in this period where we have these ... but your point is well taken, Pamela. I think it is fair to say that there's probably a distinction between how the US may navigate this type of energy shock relative to other areas across the globe. I'd call out specifically Europe and Asia where there's typically been a much higher dependency on oil being imported, as well as higher reliance on natural gas. If you take the Strait of Hormuz about 20% of the world's LNG supplies go through that. That's why we're seeing, I would say, much higher impact on energy prices in Europe and then also across Asia. I think it's not surprising when we look at some of the central banks, for example, the Bank of England or the ECB, their rhetoric I would characterize as being even more hawkish than what we've seen here in the US, perhaps even cautioning that a hike could be in the foreseeable future. That's where I think there is this distinction. The US, we've certainly made a lot of progress in terms of a higher degree of energy independence with our focus on the oil shale. Also just broadly, we're very much a service-based economy so that helps reduce the overall impact from higher oil prices as well. Nobody escapes here but I do think there are some areas that could be harder hit in this backdrop.

[00:20:56] Pamela Ritchie: It's interesting, and these are all leading to, I think, what you said off the top of why you remain invested the way you're invested and that hasn't really changed. I'm curious a little bit about the global story and again, where it puts sort of the US bond market because, as you mentioned, many of those countries before the oil shock that's going on right now due to the war had finished their cutting cycles, essentially. I mean, they've been sitting at the bottom or close to it and had started cutting earlier so the differential had been there already. Again, I guess, just weave that into your thesis for how you are investing.

[00:21:39] Christine Thorpe: Again, taking that long term view, we've had for a long time now allocations to global credit as well as emerging market debt. From our perspective you just get broader diversification benefits from expanding the opportunity set by investing in areas outside the US. From our perspective we had increased at some point our allocation to global credit, this is going back a few years now, exactly to your point about the difference in terms of where the Europeans were in their cutting cycle relative to where the US had been so certainly had benefited from that. By and large we haven't seen significant opportunity yet within global credit so have not been increasing our allocation. Certainly, as things get more interesting perhaps that's some opportunity to add. I will say with respect to emerging market debt, EMD had a phenomenal year last year. They were the top performing sector within fixed income in double digits. That was a home run to have some of that exposure there. We had some really nice security selection opportunities within that sector that benefited our portfolios. There's probably not too many more gains to be taken. Their spreads have continued to move really tight. We're sort of back to this environment where we've got to be patient and really haven't seen an opportunity to add significantly there.

[00:23:38] Pamela Ritchie: It's always the thing that you don't know, it's the bump in the night that creates the catalyst, so it's impossible to say what it is but what would it be? What would be that catalyst?

[00:23:50] Christine Thorpe: I wish I had that crystal ball, Pamela, it would make it easier. There's a couple other factors apart from this energy crisis that we're facing and sort of the follow through impacts to the consumer and growth expectations. Other areas we were even looking at before that, I think there's been concerns about what's happening in private credit. There's been a tremendous amount of headlines here in the US about certain products and investors being able to redeem from structures where perhaps they thought there was more liquidity than there was. We haven't seen really a lot of contagion from some of these headlines in private credit. It's still very much an institutional market. Leverage is still fairly low compared to previous credit cycles. From our perspective doesn't seem to be a huge source of volatility for us but certainly bears watching.

[00:25:15] The other area would be just the continued AI spend by the hyperscalers. We've seen them really tap the bond market in a significant way over the course of last year. We saw about 200 billion in investment grade corporate issuance related to that and expectations are going to be similar to that, if not higher, over the course of 2026. So far the market has really digested that supply but as net corporate issuance really continues to move higher at some point that could cause the market to blink, and maybe that's an opportunity. Hard to say at this point. I'll just say, Pamela, there's always the unknown unknowns. We think back to the last even six years or so, global pandemic, the 2022 cycle that we talked about, regional banking crisis in in 2023, those were all periods where spreads moved significantly wider and I'd say nobody really had that on their bingo card, so to speak. You can't prepare for those but I think that's just where our process is, when spreads are tight you bring down risk, you have a lot of liquidity, and you're ready to take advantage of those opportunities.

[00:26:50] Pamela Ritchie: It's fascinating how you'll do that. If we could just go a little bit across the asset classes themselves. High yield has been a really interesting place to be. Tell us just a bit more about the safe haven. We sort of began the conversation with the US bond market has always been the safe heaven but is there something more electric about that now, or do you see that happening in the future? Just the safety of it and where it goes, and also providing some income. I mean, there's a nice coupon there to take a look at for many investors who would be happy clipping that rather than worrying about the risk. I wonder if you can just sort of delve in there on the asset classes and also the opportunity for income.

[00:27:39] Christine Thorpe: I think you hit it on the head just with the point about yields continuing to be elevated. The yield on the Ag still probably in the 70th percentile compared to the last 20 years so still very high versus where we've been. That is a nice opportunity to earn that income. I also think from a total return perspective that provides a lot of cushion. Even as we see prices in bonds come down as part of the sell-off you still have a lot that yield to offset some of that. That's why we have our own proprietary risk models where we run 5,000 simulations every night. It's much harder to generate...

[00:28:38] Pamela Ritchie: That's a lot.

[00:28:38] Christine Thorpe: It is a lot. It's much harder to generate in those simulations a negative return for the bond market. There's just a lot more upside with that higher starting yield. What I would say is that view also extends across asset classes. You mentioned high yield, for example, high yield ... spreads have moved wider but again we're not even at historical medians or beyond that. On top of that right you have that high starting yield so that's going to be a similar cushion. The other way we think about high yield is that it's got a shorter duration than investment grade corporate, that shorter duration also means there's a little bit more cushion from that perspective in terms of even as you get some spread widening you may not get the same level of price decline. That's kind of why we think even in periods like this high yield, leveraged loans, play an important part of our diversified portfolios where we can still get some some upside from those sectors even despite a lot of this volatility.

[00:30:02] Pamela Ritchie: Is it either fair, or I'll ask you to comment on, are you staying away from areas that could be disrupted by AI, essentially? It's sort of the software question, isn't it, but in terms of lending and where you want to be exposed where are you avoiding?

[00:30:22] Christine Thorpe: It's funny, actually, our high yield and our leveraged loan teams had either been reducing a lot of their exposure to software or underweight the sector relative to their respective benchmarks. That's actually helped during some of this sell-off. I think that the story in software, first of all, perhaps not all companies are equal. There are many software companies that are still cash flow positive. They may be fully integrated across enterprises so much more sort of solid fundamentals. That's where I do think that security selection expertise is going to be really important as you're looking at who may be winners and losers. It doesn't mean you can avoid all the losers but the goal is to have a higher batting average over time. I think that's part of it. I'll say just on the investment grade corporate side we've been very selective. We don't have a big allocation to technology broadly. A lot of the AI issuance I mentioned has come at very tight levels even inside the index. A lot of these companies are single A or even double A. It's just too rich for us to see much value there. Again, perhaps there's an opportunity down the road but not anything we've been adding in any big way.

[00:32:05] Pamela Ritchie: Christine Thorpe, a calm within a storm it sounds like at the end of this conversation. Is there anything you'd just like to leave with investors as sort of a final thought or a message?

[00:32:18] Christine Thorpe: I think there's there's a lot of noise, there's a lot of headlines, you've got to really look beyond them and just be thoughtful about how you're making shifts in this type of an environment. Again, for us it really matters how a lot of this is translating into what we're seeing in the market so we're just trying to lean into all the resources we we have. We're talking to our energy analyst who covers it from an equities perspective, our oil analyst that covers it from fixed income, our inflation analyst. We're just trying to bring all of our resources to bear as we we navigate this. Really, from our perspective, we think fixed income, still attractive given all-in yield and we're just going to continue to be patient and really wait for that better opportunity to add risk.

[00:33:13] Pamela Ritchie: Best way to end of Friday, speaking to you. Thank you very much for your time and a good weekend ahead. Christine Thorpe, thanks for joining us.

[00:33:21] Christine Thorpe: Thank you.

[00:33:23] Pamela Ritchie: That's Christine Thorpe joining us today on Fidelity Connects. We go to next week now, next Monday Fidelity Director of Global Macro, Jurrien Timmer, will kick off the trading week with you armed with incredible charts and graphs that he will help illustrate the macro themes on his radar, probably should be on your radar as well. The webcast will feature live French audio interpretation.

[00:33:43] On Tuesday portfolio manager, Mark Schmehl, is back for another lively discussion on global markets and the emerging trends shaping his outlook and portfolio positioning. This webcast will feature live French, Mandarin and Cantonese audio interpretation. Please join us in any of these languages. We'd be delighted.

[00:34:02] On Wednesday join our Directors of Tax and Retirement Research, Michelle Munro and Jacqueline Power. This is for a practical, timely, as we approach tax season, walkthrough of what you need to know to guide your clients through the final stretch of this tax season. They're going to be breaking down key changes, common filing pitfalls and the strategic considerations that matter now that the RRSP window has officially closed. Jacqueline Power is going to be joining first at 10:30 a.m. Eastern for a French language webcast and then she and Michelle will join us here at 11:30 Eastern time in English. Thank you for watching. Have a great weekend. I'm Pamela Ritchie.