Fund selectors cut duration as ‘immaculate disinflation’ narrative wanes

Yield curve positioning is one of the big calls for fund selectors in 2024

Tom Eckett

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Fund selectors are eyeing the short end of the US Treasury yield curve amid expectations the Federal Reserve will be unable to cut rates in line with market forecasts.

The risk of stronger-than-expected US inflation is one of the key drivers behind this, with the latest figure rising to 3.4% last December, ahead of 3.2% forecasts.

The print comes after a sharp rally in long-duration bonds late last year following the Fed’s unexpectedly dovish pivot at its final Federal Open Market Committee meeting of 2023.

This led markets to price in as many as 175 basis points (bps) worth of US interest rate cuts in 2024 as investors became increasingly bullish about the prospects of the ‘immaculate disinflation’ narrative.

The latest US inflation reading – combined with the US economy’s resilience – leaves plenty for fund selectors to consider, especially given soaring oil prices following the US-led strikes in Yemen.

Alex Brandreth, CIO at Luna Investment Management, said global conflicts combined with US reshoring has created an environment where inflation could be more sticky than market expectations.

As a result, he recently allocated to the iShares $ TIPS 0-5 UCITS ETF (TI5G) to lock in higher yields at the shorter end of the yield curve.

Markets are still wedded to the disinflation narrative, with traders pricing in a 38.9% chance of 175bps of rate cuts from the Fed in 2024, as at 16 January.

“TIPS currently have a positive real yield in the US which is attractive,” Brandreth told ETF Stream. “We believe there will be three or four rate cuts in the US but not the amount the market is anticipating.”

Echoing his views, Wei Li, global chief investment strategist at the BlackRock Investment Institute, said geopolitical fragmentation is a key reason why the Fed will not be able to deliver the rate cuts markets are currently forecasting.

“In fixed income markets, we see more volatility ahead partly as inflation’s persistence becomes clearer,” Li said. “We are keeping our overweight to short-term US Treasuries.”

Long-duration US Treasuries was one of the most popular trades in 2023, with the iShares $ Treasury Bond 20+yr UCITS ETF (IDTL) capturing $3.8bn net new assets, according to data from ETFbook.

However, Edmund Shing, CIO at BNP Paribas Wealth Management, has also recently reverted to short-duration US Treasuries following last December’s rally.

“There is a lot of good news priced in which suggests further progress on yields will be somewhat more challenging,” he told ETF Stream. “Because the yield curve is still inverted, we prefer to be positioned near two-year US Treasuries versus 10 years.”

In this volatile environment, fund selectors have been forced to reduce their investment horizons from a tactical perspective. ETFs allow investors to stay nimble, a key driver behind the record inflows into fixed income ETFs in 2023.