The dividends of policy divergence

Active duration management matters once again

From the vantage point of August 2024, the inflation pressures of recent years have declined substantially. Central banks, after their period of tighter policy, pivoted to a wait-and-see mode—and now are pivoting once again as they’ve begun to drive policy rates lower.

As of this writing, we’ve seen rate cuts from the Bank of Canada, the European Central Bank, and the Bank of England, among others. And we expect additional developed-market central banks, notably the U.S. Federal Reserve, to join in cutting rates over the coming months and into 2025.

This has validated our favorable view of interest-rate risk coming into the year, and we maintain this view. We see the current fixed-income landscape as having downward momentum in global yields, but we don’t see yields falling uniformly. Indeed, we expect to see rates fall at different paces, along with occasional volatility and checkbacks—temporary reversals or retracements of falling rates. This divergence in the timing and magnitude of rate changes, we think, will translate into opportunity for an active approach to global fixed income.

In other words, we can express our favorable view on interest-rate risk by actively managing portfolo duration, tactically embracing divergences in policy when and where we have conviction.

Looking beyond yield for better credits

The policy-driven duration opportunities we see are just a part of the story underscoring the merits of a global fixed-income approach. An additional part, among others, is the active role of asset allocation in managing credit risk.

At the moment, conditions in global fixed income are much more favorable from the perspective of income generation than they were in recent years. Gone are the days of zero cash rates and negative-yielding fixed-income instruments. But that doesn’t mean risk is no longer a real concern; on the contrary, we believe it’s beginning to matter more where investors are finding sources of yield.

Now more than at any point so far in the present economic cycle, we believe investors must be thoughtful about where yield is sourced—particularly in riskier segments of corporate credit, such as U.S. high yield. While we believe there are attractive opportunities here, valuations warrant being more thoughtful: Beyond yield, what's a debt holder getting in terms of issuer quality, security covenants, and sector strength?

As of late July, the spread between the ICE BofA U.S. High Yield Index versus 10-year U.S. Treasuries was approximately 300 basis points (bps). Over the last 20 years, that spread has averaged closer to 500bps. Put another way, spreads have been wider than they are now roughly 90% of the time over the past two decades, which indicates the relative expensiveness of U.S. high-yield bonds today.

This is another reason why we believe being an active investor now is so critical. In addition to being able to take advantage of policy rate divergence, an active approach to asset allocation and credit selection can help investors avoid the minefield of spread widening. In other words, a risk-aware fundamental approach may help global bond investors continue to enjoy the benefits of diversification without incurring an inordinate amount of pain from bond market volatility.

No regime change when it comes to reserve currencies

In recent quarters, investors may have seen headlines around governments wishing to move away from the U.S. dollar as the reserve currency of choice. This has occasionally prompted questions about the potential role currency risk plays within a global bond allocation. This perennial topic has reemerged in the context of so-called de-dollarization, which is a variably supported trend of certain governments expressing a desire to participate in global trade in their own currencies.

De-dollarization is, in fact, happening, but it’s in no way a near-term threat to the U.S. dollar’s status as a reserve currency. Consider, for example, the composition of central bank reserves, which the International Monetary Fund (IMF) tracks through its composition of official foreign exchange reserves. As the IMF's data shows, the U.S. dollar was a little bit over 70% of the total weight of those reserves in 1999; more recently—from 2021 through the first quarter of 2024—that weight had declined to slightly below 60%. But then consider the next largest currency within that balance: the euro at 21%. At that level, we can easily see that the U.S. dollar still has a healthy lead over other currencies.

When we look at where reserves have moved, we find they’ve been spread across a variety of different currencies. Some of the balance has gone to the dollar bloc—including the Australian dollar, the New Zealand dollar, and the Canadian dollar—and some has gone to Asian currencies, such as the Korean won and the Singapore dollar and, of course, to the Chinese renminbi.

When politically charged thinking gets involved in the question of the U.S. reserve currency status, people point to the Chinese renminbi. And it has risen—from about zero to about 2.5% to 3%. So, again, there's still an enormous difference between the U.S. dollar and the renminbi.

Furthermore, from a daily liquidity perspective, we can consider the triennial survey of daily liquidity volume in the foreign exchange market. According to the most recent survey from the Bank of International Settlements (released in 2022), over the last 20 years that market has grown from about a little over US$1 trillion traded daily to approximately $7.5 trillion (in aggregate U.S. dollar terms). Considering every currency trade involves two currencies, the U.S. dollar portion of that daily volume figure has gone from about 90% down to about 88%. There has been a slight reduction, but the U.S. dollar remains far and away the largest component of daily foreign exchange volume.

Ultimately, these changes in reserve and liquidity levels haven't materially affected how we approach currency exposures. The history of currency reserves shows that balances have always been evolving, but we believe the degree of change is better measured in generations rather than years.