Franklin Templeton discusses central banks' strategies for rate cuts and their impact on fixed-income markets
In an exclusive feature by Benefits and Pension Monitor, Franklin Templeton provided valuable insights into the ongoing question of when central banks will start cutting rates.
Clients frequently ask this question, highlighting the importance of inflation and policy rates on market returns this year.
The firm notes that central banks have made considerable progress toward their inflation targets, but they are facing a “last mile” problem.
Despite this challenge, the Bank of Canada (BoC) initiated a 0.25 percent rate cut on June 5, reducing the overnight rate to 4.75 percent, the same level as a year ago.
Mortgage interest costs and rents are significant components keeping inflation above central-bank targets. Canada’s headline inflation stands at 2.9 percent, but when mortgage interest costs are excluded, inflation runs at approximately 2.1 percent.
In comparison, the US headline inflation is 3.3 percent, with core inflation over 3.4 percent. The strength of the US economy allows the Federal Reserve (Fed) to remain on pause longer than the BoC, indicating that the challenge of achieving monetary equilibrium remains complex.
As recently as March, markets anticipated three to four rate cuts by the Fed through the second half of the year. However, the Fed’s latest “dot plot” now suggests only one policy rate cut toward year-end.
Should US growth, inflation, and employment data remain stronger than expected, it is plausible that the Fed may not need to cut rates at all this year.
The Canadian economy is in considerably worse shape than its US counterpart. Growth has slowed to a crawl, with homeowners struggling to renew mortgages at higher rates while unemployment rises and consumers cut back on spending.
In contrast, the US economy benefits from its size, diversification, and the ability of homeowners and corporate borrowers to lock in comparatively low, long-term lending rates. Although the BoC is expected to cut rates further than the Fed, this process will likely be gradual to avoid harming the Canadian dollar.
In both Canada and the US, yield curves remain deeply inverted. In the near term, curves are expected to stay inverted as central banks will likely be more patient with policy rate cuts while inflation remains elevated.
As growth and inflation fall and unemployment rises due to tighter credit conditions, the yield curve is expected to normalize as markets price in rate cuts.
Fixed-income fundamentals remain attractive, with yields at appealing levels. Credit spreads have been remarkably resilient, and the credit market is currently pricing in a soft or no landing scenario.
Franklin Templeton prefers to maintain liquidity by investing in short-duration, high-quality paper that offers a relatively attractive yield for the first time since 2007.
The short corporate part of the market is especially attractive, with yields at the highest point in the yield curve due to high overnight rates. Adding 100 to 150 basis points of spread, a one-year corporate bond can yield 6.5 to 7 percent.
High-quality corporate bonds with short maturities are relatively well-insulated against rate volatility. As the market begins to price in a recession, credit exposure is expected to increase.
Currency also plays a crucial role, with the US dollar acting as a volatility absorber and a way to make money when mispriced.
The current economic landscape, combined with higher starting yields compared to pre-COVID-19 levels, makes Franklin Templeton optimistic about the fixed-income asset class.
