Top of the Morning: Fixed Income Strategist - Optics and opportunities

(upbeat music) - Hi everyone, Dan Cassidy here. Welcome back to top of the morning on the UBS Market Moves Podcast channel. Today we will turn focus back to fixed income as we will highlight the latest fixed income strategist report from the UBS Chief Investment Office, the title Optics and Opportunities and joining me for the conversation today, fortunate to have with us to publications, lead author, head of taxable fixed income strategy for the Americas from the UBS Chief Investment Office within UBS FSI, Leslie Falkoneo. Leslie, welcome back to top of the morning. Thank you for dropping by on this Thursday. - Thank you, Dan. - Leslie, just diving into the fixed income strategist, it does spend some time reflecting on the quarter that was. So let's talk about Q3, it was an eventful period for fixed income investors of the month of September in particular. So what are your reflections on the quarter's performance and how do you see the fixed income landscape evolving through year end? - Yeah, I mean, we wrote a very comprehensive lead in the six income strategist month with Optics and Opportunities. And when we think about the third quarter and the third quarter move, it was actually quite remarkable. I mean, we, we're on the end of June, we were 437 and 10 year yields, some points at the end of August, we were on the 463 and then all of a sudden, we had both 10 and 30 year yields jump to the highest that we've seen since 2002. Now, as we all know, and this has been written about quite a bit, I mean, most of the increase in the nominal yields is driven by real yields, which does first and foremost indicate that growth is on solid footing. And, you know, are we agree with that, you know, outlook and what we've seen in the second quarter growth and our expectations for third quarter is that, you know, growth remains on solid footing, but the amount that the yields increased in such a short period of time, and that's one of the things that we always highlight that necessarily about the level, but the pace that you get there, it was very, very fast. So our outlook with that was that the market is, you know, pricing in our opinion, a more hawkish fed path than we are. I mean, it just slides back and forth, but right now, they're looking for, say, another, you know, three hikes through 27. We were looking for another two and a very, and a potential, high potential, that they begin to cut in the latter part of 2027. But really, the main reason was when we had this move in, you know, in interest rates, it wasn't just about the fact that, okay, yes, we had continued uncertainty regarding what's happening in the Middle East, but particularly at the end of the month, we saw this decoupling in the oil was actually coming down and the yields were continuously rising, and that was probably what was happening globally. It was due to uncertainty. It was due to the fact that it's not just about, you know, whether these supply-driven inflation concerns are going to fade, which you do believe they will, but it came up, but it came more about reaching at 2% target in inflation expectations, or in inflation targets. So, you know, that was really the main driver, and because breaking inflation expectations did not necessarily skyrocket, and they didn't throughout the quarter, and you know, particularly throughout the month, it's really looking at how long does it take to get to that target, and that uncertainty has allowed for, or, I should say, investors demand, demanded a bit more compensation when it comes to investing in the long end. Now, you know, what we see today, and, you know, one of the plays that we had made was that we added our interest rate risk in this backup, there's no question. We added a little bit too early. We probably added around that 5% level, you know, moving from short end treasuries, which we still hold, but adding risk assets in that, you know, five to seven or intermediate part of the curve as yields rose. You know, for a moment for a couple weeks, we, obviously, were hanging our head a little bit, just how quickly race moved, that 535 and 10-year treasury yield levels, but now we're actually back down a bit, and more importantly, we're down, even though some of the inflation numbers are not necessarily abating, but the market's already pricing this in. So, when we think about how we go to your end, you know, our expectation is, is that more than likely once you're gonna have volatility, there's no question, we saw volatility spike, we think that's gonna continue to happen, not just because of some of the, what's happening in the Middle East, or the uncertainty regarding fat action, you know, the midterm election, all these kinds of variables might keep volatility high. We still think it's a good idea and prudent to start sort of average costing and adding on to that industry at risk. You don't necessarily chase rallies, but what we do is that we wanna add to interest rate risk as these rates rise. And what we're seeing today is, because of some of the corrections that we're seeing within the equity market, we have had strong CPI and PPI numbers, but the yields continuously go down in the treasury market for two reasons. One, they moved up way too fast, and in a much shorter period of time, and normally when that happens, it's not a sustainable move. You know, and two, again, the market's already pricing, pricing in a fairly hawkish outlook. So, you know, we like to stay in the short end of the part of the curve with the treasury side, we're in the intermediate and risk assets, which we continue to like mainly in high quality, but we do have dabbing in, and what we call these carry type trades, whether it's preferred or high yield, but we're mainly in the high quality sector in that five to seven year area. And we do look for yields to trend lower into year end. And during 2027, as we see, you know, growth start to slow a little bit, but again, it is not a straight line. So, you know, investors need to be cognizant of, you can see volatility, you don't have to chase markets, you wait for the right opportunity in terms of when those yields start their highs, which they will again, where we've come down quite a bit in the past couple days, but we're not in the all clear yet. So, and that's really how we're playing it. - Well, a lot of factors at play, impacting fixed income return. You mentioned inflation as well, Leslie. We had at this appointing a print there this week, and we'll dive a bit deeper into positioning in a few moments. I do want to single out the widening and credit spreads. Investors have taken notice of that in recent time. What does the widening and credit spread signal to you, Leslie? - You know, right now, it's really simply more of a normalization. I mean, you're widening from incredibly tight levels, and we have written every time throughout the past most of this year, how tight the spread range has been for both things like, you know, either whether it's investment grade corporates or high yield, both a higher and the lowest spectrum credits. You know, really, we're in a very, very tight spread. So, we're seeing some widening out now. I think as volatility has risen, you know, as real yields have gone up, while that does signal a growth, strong growth, it also can impact what we call financial conditions, which have been tightening as rates rise and borrowing costs are higher, obviously. But we don't look at these widening spreads as some sort of catalyst going forward. If anything, we view it in more of an opportunistic fashion, because again, these balance sheets, both household and corporate balance sheets are in healthy positions. The yield that you're earning, and I know we'll talk about, you know, our allocation in a bit, but again, what we highlighted in the six income strategies was just how much that compounding income is a tailwind to the total returns. And so having the spread widening, if this isn't something that we think is a red flag, and we think it's a normalization, it could continue for a little bit as volatility is heightened. But overall, we think the fundamentals are intact, but you are seeing and have seen throughout this year a dispersion. And we think that's going to continue. So you need to be selective in higher allocating. - And Leslie, as I was reading through the fixed income strategies, something that jumped out to me, agency MBS. Posted its worst monthly performance in September, a since 2022, curious as to how much did rates volatility factor in there to performance and are there concerns about any underlying fundamentals? - Yeah, I mean, Dan, honestly, it was a big, big performance driver in terms of those headwinds when you talk about rate level and volatility. I mean, we like the agency MBS sector. We had an attractive on it in 2025. It was one of the top performing sectors. And it actually was doing very well, or at least as expected in that carry staying in there, within a tight spread range, similar to the investor grade corporate side. But when you have, again, it's not necessarily about the level but the pace of the rate move, when you have a move that we saw in September, where within a week and a half, you're going up 30 basis points or so in 10-year treasury yields. Sector such as agency MBS do have a bit of an issue keeping up, so spreads widening. And now I did a widen because of the volatility, but obviously the mortgage rate is now, that the time was over 7.5%. It's much higher than what it has been in the past year. But I also believe too that when we think about the holders of agency MBS, more than 53% are outstanding mortgages are locked in. You know, let's say we're on that 4% level. So when everyone talks about this, they always talk about what we call this negative convexity in agency MBS market. It really, it comes to fruition more when you have these sharp moves, because overall the convexity profile in mortgage-backed securities has improved tremendously, since the COVID, and since we saw that 60 basis points in 10-year treasury yields. But this kind of volatility that we saw is a little sharp move rate, this sharp rise, and whether it's a move index or swaps in volatility, definitely had headlands on. performance. You know, we've kept our attractive. We don't think that, you know, you're going to see that spike with that same magnitude going forward. That doesn't mean that yields aren't going to rise or have pockets of increasing yields. But again, it's not just about the level. It's about the pace. We just don't think we're going to have that drive in terms of that those dramatic moves. So we do like the agency MBS market. We think it's a great diversifier. We like the high quality. We like the liquidity. And what you're getting in yield for some of these current coupons is a great talent to totally return, particularly given the credit quality versus the IG corporates. Leslie, as we begin to close out just to reinforce some guidance as you've pointed out with rates, volatility still heightened. How should fixed income investors navigate this environment and what are your positioning recommendations at this time? You know, I think the biggest, I think the most important thing when we think about the levels that we locked in at and the cushion that it provides. I mean, I can't emphasize again, you know, and I think people really have a tendency to take this for granted. When we say yield levels, not since 2002, 2002, these hours. So it's not like all their cheats will sit from 2025. We're talking about all the decades, the highs and yields. So I really don't discount the amount of cushion that you have from this compounding income that we see will be a driver of returns. It's very important not to worry about the next 25 basis points or 30 basis points up or down because unfortunately we are in an environment with a lot of unknowns. You know, if we look at yields rising globally, the fact that the market has, you know, a hawk is fed. We're not, don't know how long this billies crisis goes on for. We have midterm elections. We have supply. I mean, all these kinds of variables are going to push, you know, performance back and forth. But overall, we do think that the economy stays on solid footing. We do have, you know, gross slowing in the months ahead, but, you know, at least at trend. We do think the Fed will probably, you know, hike two more times, which is not a huge headwind to risk asset performance. It's simply 75 basis points of hikes is return of some of the cuts they did in 2025. But how we are positioned with this is that, you know, we are keeping our portfolio diverse five. We have mostly high quality in there. You know, we do have some, we consider, you know, lower credit quality, whether it's for $25 preferred, that it had some of their worst yearly returns in decades, it's not ever. And some of the high yield that we had added on when spreads started to widen out, we're going to keep those positions on. But we mostly have a diversified in that five to seven years. We have both high quality. We have a little bit of carry from that, from those credit components. But we extended our interest rate risk out to the intermediate part of the curve. You know, we're still slightly cautious on the back end, just, just, that's just tactically because the volatility structurally, we think yields are, are cheap. So if you are buy and hold investor going into, you know, long and munis right now, given those tax equivalent yields is a great opportunity. But again, we do think volatility is going to last, you know, for the next six months or so, just given all of this uncertainty that we have. But we do have a diversified portfolio. We extended interest rate risk. We're not worried about every 25 basis point moving 10 year treasure yields because it's going to happen. But over the next six months, we look for it for yields to go below 5% anywhere between, say, four and a half and five for 20s, 27. You know, we do look for the Fed to hike in December as the market is already pricing in. And we think that risk assets, while spreads may go through pockets of vulnerability of widening, the income that you're earning will bark of you a cushion in terms of spread widening because we don't think there's going to be a catalyst in the economy going forward. Well, Leslie, very helpful touch base this morning as it has been a challenging environment for fixed income investors. So do appreciate your clarity and a guidance on how to navigate this environment and how to position accordingly. And of course, we do look forward to having you back again soon. Thank you, Leslie. Again, today we have been joined by Leslie Falkonio, head of taxable fixed income strategy for the Americans from the UBS chief investment office. Again, do you want to highlight the October edition of the fixed income strategist publication, which Leslie has been referencing on today's episode optics and opportunities is the title of this report now available for you where listeners are clients up on UBS.com slash CIO for clients of UBS. Please be sure to reach out to your UBS financial advisor to receive a copy of the latest fixed income strategist report directly from UBS studios on damn Cassidy. Thank you for joining us. Thank you for tuning in. Be sure to visit UBS.com/studios to view the entire UBS studios suite of podcast channels along with their video offerings such as UBS trending. You can also follow us on Instagram for content highlights at UBS trending. UBS studios is part of the UBS chief investment office within UBS global wealth management. Visit UBS.com/CIO to view the latest research. This material has no regard to the specific investment objectives, financial situation, or particular needs of any specific recipient and is published for informational purposes only. For information, please visit our website at UBS.com/workingwithus for a full legal disclaimer applicable to the independent investment views produced by UBS. Please visit our website at UBS.com/CIO-disclamer.