FidelityConnects: The future of monetary policy and what it means for your fixed income portfolio

[00:04:10] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. Markets continue to plow through all Federal Reserve headlines without too many hiccups. A surge in equities followed a dovish Jackson Hole meeting last week, and though tamped down a bit higher yields in the long end bond markets are some of the only waves being made in reaction to potential firing of a Fed governor. Can markets continue to be resilient and push through the noise, or is an extra look at safety in the form of bonds worth investors' time maybe more than ever. Will key economic data due out over the next days and weeks still influence the Fed to hold, possibly? Or must the Fed now sit squarely looking at the labour market's relative weakness from here on forward? To unpack the direction of travel for monetary policy and what it all means for the fixed income landscape and how Fidelity is actively managing its bond strategies for unit holders we're delighted to be joined by Fidelity institutional portfolio manager, Christine Thorpe. Great to see you again, Christine. How are you?

[00:05:10] Christine Thorpe: Hi Pamela, I'm well. Thanks for having me.

[00:05:13] Pamela Ritchie: Delighted to have you here. We're very happy and we'll remind everyone who's joining here today to send questions in. Go ahead and do that and we'll put those to Christine over the next 30 minutes or so. I wonder if we can begin with this discussion of resilience because it does seem like the markets have gone through ... people were exhausted, they were saying, in June but anyway, the market continues. It's been a fascinating volatility story. There are stories in the long end bond market but why otherwise do you see markets relatively resilient?

[00:05:44] Christine Thorpe: I think that's the right question, Pamela. What I would say is even in the face of the resilience we've seen in markets I do think there's still a wide range of potential outcomes from here. There's many different, both headwinds and tailwinds at play. As our macro analyst likes to say, the U.S. economy is currently in a state of suspended animation, which I think is a good way to put it. From my perspective, when there's such a high degree of uncertainty and at the same time valuations are extremely tight I do think it makes sense to be cautious and pull in risk and really stay liquid. I'm sure we'll talk about it but that's how we're positioning our portfolios.

[00:06:34] If you take the U.S. economy, I think the strong valuations we're seeing are probably warranted to a degree. Corporate earnings have continued to surprise to the upside. Balance sheets are in good shape. Consumers are still spending although you are seeing more weakness in the lowest quintile. At the same time there's these big questions out there around  what is the ultimate impact from tariffs, who is, ultimately, going to be on the hook for them, and what is the read through to inflation? We're also starting to see some weakness and cracks under the hood in the labour market. With all of this there's a lot for us to digest as fixed income investors but, certainly, the Fed as well.

[00:07:23] Pamela Ritchie: We're delighted that you're doing that for all of us. That's the important thing. Let's sort of talk a little bit about the long end, what we've seen with yields recently. We're talking about the 30-year bond but that said, there's also a discussion of sort of a shorter term. For a very long time, it seems years, there was a big no, no, we're not playing in the realm of duration yet. It was always that we're not looking there yet. That was probably a last year story. To what extent are you playing, actually, in the longer term bond market at this stage?

[00:08:00] Christine Thorpe: Overall, across our strategies, depending on the particular fund in question, we are leaning slightly long duration. In a strategy like Multi-Sector Bond we're about half a year long relative to the U.S. aggregate bond index. From our perspective, yields here are really attractive, yield on the Agg are still close to the 80th percentile relative to the past two decades. I think that's certainly been pretty compelling from our perspective. At times we have leaned into the 30-year Treasury. We call ourselves gradual contrarians so as we've seen some of that sell-off, that's been a chance for us to add a little bit more exposure. I think what we should expect out of the long end is certainly probably more volatility. I think we've seen that in pretty big ways across certain pockets, April being probably a prime example where post-Liberation Day we got a pretty big rally initially and then we got the sizable sell-off, particularly, I think, due to some technical factors as hedge funds were unwinding some of their Treasury positions, perhaps asset allocators moving out, rebalancing out of fixed income into equity given the degree of sell-off we saw there.

[00:09:31] Overall, we have seen a little bit of a ceiling on the 30-year from a yield perspective. It was when the administration really said the bond market started to get yippy and when they implemented that 90-day pause that you saw yields really stop selling off. I think it's hard to always call exactly where we're going from here but it does feel like the administration's certainly paying attention. They've made it very clear that they want yields to be lower. Not always easy to do. With some of the news around the Fed and questions around its independence we continue to see a little bit more of a sell-off over the last day or so. Certainly something, again, I think to keep a watch on but yield in the 5% range, that feels pretty attractive to us. We haven't seen that in a long time.

[00:10:27] Pamela Ritchie: Yeah, it is a new world in that sense. Well, let's go sort of straight to the conundrum of what the Fed ultimately will do, to what extent it will be the same set of people running the Fed. We know that some of that is just due to dates when, for instance, the Chair will leave anyway, and is scheduled to, but it does look like there is a question about independence. Again, what do you think about the way this is being digested, ultimately, and how are investors meant to think about this?

[00:10:59] Christine Thorpe: I think certainly all eyes are on the September Fed meeting. We did get some indications, I think, out of Jackson Hole that Chairman Powell is perhaps a little bit more concerned about the labour market so it feels like September may be in play for the Fed to resume its cutting cycle. I will say, we've got more data prints between now and that meeting with the jobs report on Friday and then, of course, the next CPI print, I really think the chairman and the committee are focused on being data dependent so they need to feel confident that inflation is continuing on the right, or that they're really seeing pretty strong signs of weakness in the labour market for them to move ahead with cuts. I do think at some point they're going to be able to get there. Probably what's most important is the degree to which they need to cut and some of the pace of that.

[00:12:05] Our expectation is the Fed is going to maintain its independence. Certainly, it's become more of a watch area given, again, some of the recent headlines around Governor Cook and calls for the presumed firing of her as a governor. I would say I don't think markets will react well if we really get to a point where the Fed's independence is called into question. Certainly we've seen a little bit of a reaction like we talked about with the long bond but it hasn't been too significant yet. Perhaps that will change if we get further signs that the Fed's going to, ultimately, move away from really being an independent entity as it has operated for some time now.

[00:12:58] Pamela Ritchie: Would that provide tactical opportunities? Often you'll turn to bonds when things go bump in the night and, therefore, there's some safety there. I wonder if we just bring that to bear and sort of talk about how you might want to take a look if there is going to be something that's difficult to digest, like other things have been digested through the markets, but why would you want to look at bonds in that particular scenario?

[00:13:27] Christine Thorpe: I think in most scenarios right now, even away from the Fed, I think fixed income still remains really attractive. Again, going back to all-in yields, why do investors look to fixed income? It's for that income generation opportunity. Again, with yields being so much higher relative to recent history, I think that makes it pretty attractive from that perspective. On top of that, those high yields provide a lot of cushion. We run about 5,000 simulations every night as part of our risk model. In the vast majority of those scenarios the bond market is producing a positive total return. That's just because, again, yields are so high. That can really offset a lot of price decline. To your point, Pamela, if we see a big sell-off in the long end because of concerns over Fed independence you have a lot of cushion that can help address some of that volatility from a price perspective. I think that's, ultimately, why people, not only here, we're not the only one saying it, but others see so much attractiveness in fixed income.

[00:14:49] Maybe just the last point, you know investors want to own fixed income for that diversification benefit. From my perspective, I think investors really care about fixed income and how it's a ballast in portfolios when you see a big drawdown in equity markets. If equity markets continue to be resilient and fixed income is fairly flat or even down nobody cares about that. It's when you see a big drawdown in equities that you want fixed income to do its job. I think in periods where equity sell-offs are not driven by the Fed, we're not seeing volatility from the Fed, or due to inflation concerns we're more likely to see fixed income do its job as a diversifier. I think no matter how you cut it there's a lot of reasons to be excited about fixed income these days.

[00:15:46] Pamela Ritchie: For sure, it's fascinating, particularly at this juncture. I wonder the direction of travel with the rate story and what we heard out of Jackson Hole, which did sound like a pivot of sorts, certainly in terms of tone, does it matter to you, particularly, in the way you're investing whether there is or isn't a September cut? It's more of a sort of what direction we're going in.

[00:16:12] Christine Thorpe: Absolutely. I would say we're not banking on a cut in September. That's not how we think about it. Again, we're an aga strategy so it's a duration close to six years these days. If you remember last year at the September Fed meeting we got the 50 basis point cut right off the bat. Then, hey, lo and behold, not too much longer we actually got the sell-off in the longer end of the curve. Certainly the Fed actions will have some impact on the long end of the curve but that's not the only driver. You've got a lot of other potential ramifications from growth expectations, inflation, things like that, questions about the Fed independence as we're now seeing. It's not something that is necessarily going to drive how the strategy performs but certainly over the longer term the direction of travel will be impactful.

[00:17:18] From our perspective, we think it makes sense to have some duration on in the portfolio. Real yields are attractive from our respective. Also, we would expect that duration and our Treasury allocation to really act as a hedge if we see some type of big sell-off in equity markets, things like that. That's really how we're positioning portfolios and thinking about them in the context of the overall rate environment.

[00:17:48] Pamela Ritchie: Across portfolios can you give us a little bit of a high level on allocation and exactly ... I think you were mentioning in April there was an opportunity there that maybe you got some different exposure. Can you take us through the exposure and the positioning that you've got right now?

[00:18:05] Christine Thorpe: If we go back to maybe the pre-April period, again, we've been in this environment where yields have been high and spreads have been really tight. As we lean into our investment process step one has been if we don't really see much return potential in the market we're going to take down risk. Particularly, when valuations are really stretched that's where we don't think you're getting necessarily paid to take a lot of risk so we'd rather take down our spread exposure and instead hold a lot of U.S. Treasuries. The pre-April period, our Multi-Sector strategy had over 50% in U.S. Treasuries because from our perspective they really offered the best risk-reward profile in fixed income. Heading into the April period we had a lot of liquidity on hand. I think we thought it was going to be a bigger opportunity than it ultimately was. Investment grade corporate spreads were incredibly well behaved. We went from 80 over to about 120 at the wides on the index. Now, that wasn't even at the historical median of 130. If I look at other periods where we saw really big drawdowns in the equity market, regional banking crisis in 2023 when investment grade corporates got out to 160. From our perspective it wasn't a real big buying opportunity, particularly on the investment grade side.

[00:19:49] High yield corporates did get a little bit more beaten up. We got out too closer to the 40th percentile. That was a good chance for us to dip our toe into the water. I will say it was a very short-lived opportunity so we added about 3% in high yield corporates, funded it through our U.S. Treasuries, and then spreads snapped back in pretty short order with the 90-day pause. Thought, again, we were going to have more of a bite of the apple, that didn't play out. Today we've got about a 10% allocation in high yield corporates, 10% in leveraged loans, 10% in global credit, and then the biggest portion of the portfolios is in U.S. Treasuries. I think what we learned from April is, hey, you've got to stay liquid, you have to be ready to move quickly. That's why I think it really pays to have a lot of U.S. Treasuries on hand that we could deploy in short order. I don't know what the catalyst is going to be for spreads to get wide enough for us to get excited about them and want to add risk but certainly think at some point that opportunity will come and we'll be ready for it.

[00:21:06] Pamela Ritchie: That's because spreads are quite tight now?

[00:21:10] Christine Thorpe: That's exactly right. Investment grade corporate spreads are literally in the first percentile so essentially at all-time tights. Again, I think fundamentals have been strong so to a degree you can understand why the valuations are so tight but it's really hard to see how spreads can move meaningfully tighter from here. I think the math really supports having a lot of U.S. Treasuries.

[00:22:03] Now, again, like I said, I don't know when we're going to reach that historical median or perhaps go through it but I think it's reasonable to assume at some point we will. So if we're not getting paid to take risk we think it doesn't make sense to hold a lot of that exposure. Investment grade corporates are below 10% of the portfolio today, really, a very small allocation but just means we have a lot of room to add when we see a more attractive opportunity.

[00:22:41] Pamela Ritchie: So interesting. There's some questions rolling in now that take you a little bit further afield and maybe fit with the bump in the night. We don't know what that's going to be but if it is international. One of the questions here is, is the administration likely to impose financial repression at the long end of the yield curve? Sort of the control question. What do you see on that front?

[00:23:04] Christine Thorpe: Again, I would put that in the scenario of something the market would not react favourably to. Again, hard to make a prediction here in terms of what actually ends up happening with the Fed composition and who steps in for Chairman Powell when his term is up in May of next year. Most investors will agree that if you look at a model like Japan where they have had yield curve control and where the Bank of Japan owns 50% or more of the outstanding JGBs versus where the Fed today only holds less than 20%. The Japan model is not the direction where I think investors want the Fed to head. I see it as a very low probability, most likely, but certainly bears watching and understanding. I think we'll probably get more insights as we move through the nomination process for the next Fed Chair.

[00:24:19] Pamela Ritchie: Question on deficits, which I was going to ask you about as well. This is a great question because this is what you will certainly be looking at all day, is there a higher risk than usual that huge government spending may lead to higher yields? This is one of the questions, isn't it?

[00:24:37] Christine Thorpe: Yes. I think, again, all are aligned that the current level of spending in the U.S. is not sustainable. Generating annual deficits of 6 to 7% when we're not at war, we're not facing a pandemic, anything like that, it's just very hard to justify. We did see some reaction to the markets at some points as the one Big Beautiful Bill, our large fiscal spending legislation was working its way through congress, there were concerns about the degree of funding levels within that Act. You did see some market sell-off more in the timeline around May but, again, the long and has been fairly contained. It does seem like the market is pricing in, I think, already a lot of these concerns and there, again, may be a ceiling from that. I think the market understands it's not ideal but perhaps the levels that the long bond is at today somewhat reflect the risk from those deficit levels.

[00:26:02] Pamela Ritchie: Question here about opportunities in Europe or further afield. Maybe you can tell us a little bit about sort of the universe that you manage.

[00:26:10] Christine Thorpe: Absolutely. I mentioned we do have about a 10% allocation to global credit. That's managed by our team in London. That's predominantly investment grade credits out of the Eurozone and the UK. I think from our perspective it's a nice diversifier for the strategy. We've been as high as a 20% allocation to that sleeve in prior periods, particularly during 2020 to 2022 when rates in the U.S. were so low and there was a little bit more weakness in Europe. Again, it's been helpful from that perspective. We do hedge all of that exposure back to USD. Currency volatility can be two to three times out of bond vol so we want to take that out of the equation and really translate all that back to USD.

[00:27:15] We will have some limited exposure to emerging market names as well. Names we own in the portfolio include things like Pemex, the Mexican oil producer, as well we have some unhedged exposure to Brazil. I think EM is a place where, again, you can see a lot of volatility so we try to be really selective and choosy in terms of which names we're including in the portfolio. I think today where there's still a lot of questions about the impact of tariffs, while I think we're getting closer to end state there are still, obviously, some headlines out there. Depending on the country some of those tariffs could be fairly impactful so being cautious, selecting names that we really like. Again, I'll use Brazil as an example, yields are so high we have a lot of cushion if we do have some type of price volatility. We're being selective but it's been a nice addition to the portfolio.

[00:28:25] Pamela Ritchie: Do you feel comfortable with the discussions around an actual regime change? This is back to the interest rate story that we sort of began with, of higher for longer is now switching to a path to something that looks like lower rates over time. Is that where we sit, would you say?

[00:28:46] Christine Thorpe: That's absolutely the potential for that. I'd add in one of the moves we're seeing in the bond market is this continued steepening of the yield curve. We continue to see the potential for that, particularly as we go through these discussions around Fed independence. Today the market sort of pricing in very likely seeing the potential for a cut in the September meeting but you get, with these questions around the Fed independence, the long end selling off. I do think there's the continued chance for seeing some of that. What I will say as I take step back is that I think as a bond investor there's different ways we can see this play out. If we continue to be in this higher for longer environment, I think that's fine. Yield on the agg is 4 1/2%, that's a good indicator of where returns could be a year from now if sort of nothing else changes. I'd be very happy if we continued to clip that coupon and continue to earn that 4 1/2% yield year after year for the next several years. But at the same time if we do get more of that growth scare and yields fall dramatically, I think that's where fixed income investors are going to realize a larger return over a shorter period of time. In either of those two scenarios, still very likely to generate a positive total return just because that starting yield is so high.

[00:30:35] Pamela Ritchie: That is fascinating. I feel like we should just leave it right there because that's sort of a perfect spot to leave it on. Christine Thorpe, thank you very much for taking our questions and joining us here today. Have a good rest of your summer.

[00:30:49] Christine Thorpe: Thank you.

[00:30:50] Pamela Ritchie: Christine Thorpe joining us today on Fidelity Connects. Coming up on the show over the next few days, tomorrow we're going to replay our recent discussion with John Bradley, he's Director of Emerging Technologies, and Vishal Chopra, he is equity research associate. They're covering Canadian technology, also health care, and they share how advisors can navigate both opportunity and risk when it comes to AI-driven innovation and rising cybersecurity threats.

[00:31:14] To wrap up the week on Friday we're going to be re-airing another pretty fascinating discussion, this time on how technological innovation is affecting the advisor landscape and how advisors can stay informed on the latest cybersecurity and deep fake trends. The episode will be with special guest Imran Ahmad. He is partner at Norton Rose Fulbright Canada. He's also a University of Toronto professor.

[00:31:36] Monday, of course, is a holiday for us in Canada so we'll be off air but back on Tuesday, September the 2nd, with the VP of Product, Andrew Clee. He'll be breaking down the latest trends in the investment industry and how Fidelity's product line-up is evolving to meet investor needs. Thank you very much for joining us here today. We'll see you soon. I'm Pamela Ritchie.