Transcript
Hello and welcome to The Download. I'm your host, Dave Richardson. And how could you not kick off the year by inviting your good friend, Andrzej Skiba, to come on and join us and talk about interest rates in this crazy world that we're living in as we come into 2025. Andrzej, welcome.
Always a pleasure to speak to you, Dave, and to your listeners. Happy New Year to everyone.
And you had a great holiday. You were in Sweden and Poland, which is amazing. I'm jealous.
We were lucky because initially, all the forecasts were suggesting a warm spring-like weather which is not what you hope to see for Christmas, but things turned around. In the end, there was a ton of snow, happy kids, meaning happy parents as well. So yes, great to see family and friends in Europe.
Beautiful. Then you get back home to the office, and we've got a lot going on, I guess we could say, Andrzej?
Yes, it's definitely not been a restful week. There's a ton happening in the markets as investors try to digest incoming information and prepare for inauguration of Donald Trump as our next President later in January. So absolutely a ton of discussions, a ton of views exchange across the market right now.
So, Andrzej, before we go forward, let's look back at 2024 when you look across the entire fixed income spectrum and you just think of that year from an investment perspective, an economic perspective. What are you going to remember about 2024? Any lessons we can take away from what happened in 2024 that we will be able to apply, maybe not in 2025, but at least at some point in the future? Because that's one of the things that we always stress. You want to learn from that history as you watch markets throughout your lifetime so that the next time you see a similar scenario, you know how to handle it a little better.
Well, I'm sure as investors listening to this podcast, remember, we had a very eventful year with developments on the political front, developments on the macro, investment fronts. From our perspective, some of the key messages and learnings from 2024 were to do with continued US exceptionalism, the fact that US economy has proved NACEs wrong and continued to outperform expectations throughout the year with solid job growth, but also solid economic and earnings growth within the US. The other learning from last year was the need to resist following the trend and the crowd. A good example of that was the volatility in the rate markets, where at the beginning of 2024, market was exuberant about rate cuts happening as early as in March. We got ahead of ourselves. By the time, almost every investment bank strategist was forecasting gazillion rate cuts starting early in the year, that was exactly the time to take the other side of that trade and recognize that market got ahead of itself. And indeed, that rally in fixed income was followed by a sell-off where investors came to the conclusion that actually maybe the inflation battle was not won yet. But even then, you go around the springtime to a market that was starting to consider whether there's a need for rate hikes only to reflect on actually inflation data at last improving, allowing the Fed to change its tone, having an aggressive rally into the first rate cuts in September. But then, again, market becoming complacent, expecting on a forward basis a huge amount of rate cuts in 2024 and in 2025, only to realize that the easy lifting has been done, but the battle to bring inflation to 2% might take a bit longer than investors expected. When you look at valuations in the treasury markets, it's actually the point of that first rate cut where you should have shorted fixed income exposure because yields have started rising from that point onwards as the market was considering slow inflation, moderation, new economic policy mix under a Trump win, and also very consensual positioning within the space. In all of those times, it paid off to go the other way from the broad market consensus where people became lazy in the views. So the need to challenge your views, the need to ask yourself a question, am I just repeating what everyone else is saying? Or do I actually see signs of a change in a trend that warrant action in my portfolio? That is a good learning to take from 2024 when it comes to fixed income.
Wow. I'm so glad you talked about that, Andrzej, because, again, one of the reasons I love having you on is you never just follow the crowd. You're always inquisitive You're always skeptical. I mean, there's times where maybe the consensus will be right and you want to be there, but you don't just naturally follow the herd. You step back and take a bigger, a broader look at what's going on before you make that final decision. And again, for investors like yourselves and others who took that approach last year, it was a classic year where you wanted to make sure that you didn't just follow the herd, that you did do that very rigorous analysis and have a healthy dose of skepticism in terms of the incredibly positive, exuberantly positive, and at other times, overly negative view of what was happening around the economy and inflation.
Absolutely. Look, it's not that I have a particular talent. It's the fact that we have a team that really enjoys working with each other and a culture that actually encourages team members to challenge views, to come up with different perspectives. The fact that we were able to navigate all these ebbs and flows of the market really well across all of our portfolios is a testament to how the team is working rather than any single individual. But I am very proud of the culture we have here at RBC from an investment perspective.
Exactly. And it's not necessarily about having all the answers all the time, but at least taking the moment to step back and start to ask the questions and start to do the analysis to make sure the path you're about to embark on is the right path. I was hiking here yesterday. I'm in the Azores, and so we've got volcanic craters. And so you can walk down into these lakes that are in the volcanic craters. They've done a lot of great work here improving the hiking trails, but they're still a little informal at times. You have to make sure, especially me as an old guy with a bad knee, every step I'm taking, step on a rock, step on a piece of wood, step into a patch that's a little bit wet and muddy, that I'm making sure that I'm making that right step carefully. Now, it's particularly important when you're in that hiking situation because you go tumbling down a couple of thousand feet over rock. It's not going to be a very good experience, but it's also not a very good experience when you make that misstep. It's not to say that you won't make the little misstep occasionally, but at least you're being careful enough to watch for those missteps and not being hurt by making the wrong move or, again, being caught up in the crowd that's all running in one direction.
Absolutely. This is a market where you can paint a variety of scenarios. Direction of the markets could be driven by one tweet or another. You have to challenge your positions. You have to challenge notions that are reflected in the portfolio and always be ready to be nimble and change track if that is necessary. That's been part of our secret of success over the years, where we have a team that is always engaging with each other, challenging those preconceived notions.
Yeah. And you know that most of the listeners on this podcast are Canadian, so we all too well understand the idea of the tweets and the other things that can then alter the course and change direction very quickly around things in our country. So Andrzej, we're in a rate cutting cycle with the Federal Reserve, so we're seeing those short term rates or the rates controlled by the Federal Reserve. They've come down now a full percentage point. I guess it's three separate cuts, but we've seen longer term yields actually rise, and rise significantly. And again, whereas I think if we were back talking in October and November, the consensus or the view was that these longer-term rates in the US and in other developed markets, with inflation completely under control, we're going to just come back down and fall back in line, maybe not as far, but in line with what was happening on the short-end. And in fact, we’ve reversed. And now it's a question of how high rates go as they're moving higher now. So what are your thoughts of what's happened towards the tail end of 2024, particularly the election and your view, as you said the last time, that you could see the 10-year US Treasury drift towards 5%. And here we are. We're about to kiss 4.7% today.
Yes, we do see potential further pressure on US Treasury yields, but a lot of that move higher in yields has already happened in our view. The way we're looking at the situation is you have a combination of factors. Firstly, you are likely to have elevated levels of deficit, which means huge demand for funding from US government. Then it does make sense that investors want to see a higher term premium. In order for US Treasury to issue 10-, 20-, 30-year bonds—although they don't really issue 20-year that much these days—they are demanding more compensation to absorb all that paper. That is an ongoing deficit-related pressure that you will have on treasury yields further out the curve. Then you also have to reflect on Trump policies that could have an inflationary impact. Immigration curves absolutely are likely to be inflationary in terms of impact on the labor force. But also, and even more to the point, we see meaningful risks associated with tariffs. We shared before in our conversations that we do see a potential 1% increase in headline inflation in the US if Trump proceeds with imposing 10% tariffs on most countries and higher tariffs on China. Of course, there have been rumblings of even greater increase in tariffs for Mexico and Canada. But when you think about this, 1% increase in inflation does not sound like a lot, but from a Federal Reserve's perspective, it can make all the difference between having an ability to cut rates and not. We can easily see a scenario where the Fed does not cut rates in 2025. The market is still pricing one to two cuts for the year. It's much less than was the case a few months ago, but still the market is assuming rate cuts. A lot will depend on the severity of trade proposals once administration gets into place. If you have targeted specific sector tariffs on some goods, but not all goods, and some trade partners rather than all trade partners, of course, that will be less inflationary. That will allow for the treasury markets to rebound a bit. But if he chooses to pursue a trade agenda that is consistent with what we heard during the presidential campaign, in that world, we do believe Fed will not be in a position to cut rates in 2025. And at the minimum, we'll take a pause in the beginning of the year to assess new policy mix as administration gets into place. There are multiple factors that can lead to further pressure on treasuries, especially further out the curve, especially when you look at 30-year treasuries. But it's all really dependent on the sheer extent of the trade escalation that we will see. But the good news is we should get those answers in a not-too-distant future. You might not have to wait for months on end until the market has that clarity. This is something that we might learn in the next 4 to 10 weeks. That is an amount of time that I'm sure investors can stomach before making decisions about their fixed-income exposure within their portfolios.
Yeah. Andrzej, the last time we spoke was just after the election, and one thing I think we do have a pretty good feel for is that it's going to be very difficult if he's going to be able to get at that deficit and the overall debt at all. Certainly, in his first term, he did not show any proclivity towards slashing debt. The Biden administration didn't either. So really who won the election wasn't going to be a fiscal warrior in any sense of the word. And then you look at the other policies which were inflationary. So as you postulated, you thought yields post-election would rise, and indeed they have. Do you think the markets right now, and where those long-term yields are sitting today, do you think they accurately reflect the risk? Have they built in all of the risk of what could potentially happen? Or are they still sitting in the middle waiting, as you say, for the next 4 to 10 weeks when we get some better answers?
To a large extent, yes, but not entirely. The fact that the market is still forecasting between one to two cuts this year suggests that there are many investors who expect the final outcome to be more benign than some of the alternatives. It's also from our conversations with US allocators, with US investors. It's pretty clear that most believe that in the end, administration agenda will be relatively benign. Lots of bluster, but not so much action. We would not be so quick to dismiss all of the rhetoric from the campaign. We think it's a dangerous strategy. And as was highlighted in recent days, where initial reports by the press about much more targeted tariff measures were very quickly dismissed by President Trump himself, saying that the package will be much broader and more aggressive. We really would prefer to wait for the moment where we have clarity about the policy mix before re-engaging with fixed income assets across the board. But at this stage, we prefer to wait and hide in shorter duration assets, two, three-year bonds, that are less sensitive to daily volatility in fixed-income markets, but offer you very attractive yields, by historical standards. So a nice place to hide in until that policy clarity is gained.
Where I am in the islands, a tiny island in the middle of the ocean, we get 70, 80 km an hour winds at night this time of year. And I like to sit out on the porch. And generally, I remember to bring the chairs in. So the wind just whistles by, all those threats of the wind, but we're securely inside. But the one night that I left my chair sitting outside, so left something for that bluster to get at, it ended up in my neighbor's backyard as the wind picked it up and lifted it away. So you don't want to over-expose yourself to the potential risk, and as you say, find a safe place to sit down until you find out exactly the impact of these policy changes and how broad they're going to be.
Absolutely. And besides the point that I'm getting increasingly worried about your travel habits being in places where cliff paths are dangerous and winds are so elevated, it is true that it's not a time to be a hero in fixed income right now. Shorter duration assets is a place where you can hide. Still, the big difference compared to recent years—for example, compared to 2022—is that unlike in that horrible year for all kinds of investments, this time around, the yield of the asset classes we're looking at is quite high by historical standards. That protects you in a meaningful way, even if you have continued upward pressure on yields because those securities are less sensitive to that rise in yields. And the coupon, the yield of individual investments of the portfolio, actually does most of the legwork for you. So that is what we affected across most of our strategies. High yield is already shorter in duration terms than other parts of fixed income universe. But in investment grades, we have booked profits on a lot of longer duration bonds and reinvested those proceeds in two- and three-year securities. So we're hiding in that.
Yeah. And I'm shorter man, so I can stand in the winds. I'm also a little stout as well. So I've got a good base in those stiff winds. So being shorter is better. As you're suggesting. And you say that's the same as we look out in the high yield and corporate bonds as well. You're still not wanting to be overly aggressive there?
In high yield, you have a bit more protection because that asset class is less rate sensitive. When you're looking at the highest quality segment of high yield universe—so double-B rated bonds—they have proven to be truly rate sensitive. But when you go lower down the rating spectrum, looking at single-B rated issuers, triple-C-rated issuers, there's less rate sensitivity there and you are more assured of your return because of the yield profile of those securities. So across our high yield portfolios, we're underweight within that double-B segment that is rate sensitive, but we focus attention on the single-B part of the universe and hiding there. In high yield, when I look on a forward basis between investment grade and high yield, the confidence you have in seeing at least mid-high single-digit forward, 12 month returns in high yield is greater because that treasury yield is a much smaller part of the coupon in these securities, so you're less rate sensitive. And for as long as US economy is doing well, you should be pretty assured of returns in that range. In investment grades where spreads at multi-year tights in many markets, you're really relying a lot on the forward path for rates. If we do see a relief rally in treasury markets, you could easily see double-digit returns in investment grade. But equally, you can see scenarios where higher-for-longer rate environment persists. Investors start worrying about the risk of rate hikes rather than rate cuts. We see low single-digit returns because the yield of the asset class protects you but does not help you to deliver meaningful return over this period. Investment grade looks quite binary at this stage, and that is exactly why, particularly in investment grade, we encourage investors to wait for clarity in terms of the policy mix and the Federal Reserve's response before deciding whether to stay in shorter duration securities or whether all the news is in the price and it's time to reengage further out the curve.
A lot of investors are at their target weights around stock and bond holdings right now. They're at a neutral weight in bonds. Does that seem sensible to you, given where we're headed in 2025? How do you think the fixed-income investors fare? When we're sitting here having this conversation a year from now, how do you think they'll look back at 2025 as a year for fixed-income investing?
Well, how many times have you seen cases where fixed-income investors tell people to go into equities? Of course, people always will say that fixed income is a safe, predictable, good place to be in. I'm not going to be different. But from my perspective, the fact that you can earn mid-high single little-digit yields in short-duration assets across many ratings—so it really depends on your risk tolerance as an investor—but you get nice yields to sit out in for the time being means that the asset class should form a significant portion of your portfolio, as other markets could be volatile because of that evolving policy mix in the US in response of other partners to it. Because it's not just about US tariffs, it's also about the extent of retaliation that we will see from global trading partners that matters. In that world, getting paid mid-high single digits from a yield perspective and then having the optionality once the dust settles, once that policy mix is clear, once we know how the Fed will respond to it to potentially reengage reach with the asset class, take advantage of the fact that there are a lot of yield-hungry investors out there and that could boost valuations in the second half of the year as people make peace with the new policy mix. That can take you into double-digit return territory under some scenarios. It's not a bad place to be in fixed income. We had a few years in the past where we were talking about what income do you get in fixed income, where yields were pathetic. This is not that time. Absolutely, I would argue for fixed income playing a meaningful portion in your portfolios, but the extent to which you engage with the asset class really should be driven by your risk tolerance. Again, we suggest shorter duration securities for the time being until that policy clarity is gained.
Well, Andrzej, that's a great look back and a very interesting look forward. I'm looking forward to connecting with you regularly through the year on the podcast so our listeners can get updates from you. They're always so prescient, and we always appreciate you joining us. Wish your family a Happy New Year from all of us, and we look forward to seeing you maybe a couple of months from now.
Thank you very much, and we wish you a happy New Year and a prosperous 2025 to you and all of your listeners. It's always a pleasure to connect and exchange views across the border.