How To Manage Investment Risks with Rising Inflation and Currency Fluctuations

In the wake of recent political shifts and global economic challenges, investors are navigating a complex landscape filled with both opportunities and risks. The possibility of high tariffs under the Trump administration has sparked intense discussions about their potential impact on the US domestic economy. While tariffs might initially seem like a pro-growth strategy, they carry significant repercussions, from driving inflation to causing short-term bond market volatility.

At Fixed Income & FX Leaders’ Summit 2024, Christopher Crea, Sylvain Baude, Ulfred Wong, and Mitul Kotecha delved into these pressing issues, offering their insights on how to strategically navigate this uncertain terrain. They highlighted the importance of understanding the ripple effects of US dollar fluctuations, the devaluation of the Chinese yuan, and the resilience of the Japanese yen. With cautionary advice on long-duration bonds and a keen eye on emerging market (EM) opportunities, our speakers provided a roadmap for investors aiming to thrive amid these challenges.

Join us as we explore the intricacies of the current fixed income market to equip yourself with the strategies needed to enhance your investment portfolio.

What is the most likely scenario for FI, are things going to be worse in the short term (especially until 100 days of Trump 2.0) before it gets better after a year?

In the short term, panel consensus is cautious in terms of the potential impact on Asian bonds and currencies, as the threat of tariffs and growing trade policy uncertainty will be viewed negatively leading to souring investor sentiment causing possible short-term volatility in bonds and rates.

Risk of slowing rate cuts in the US, due to inflationary pressures emanating from the new policies may impact EM local bond yields early 2025, though counteracting measures like currency depreciation and domestic growth would be tracked closely. Various Asian economies might be uniquely positioned, and the market disruptions would provide active bond management.

Recent Index inclusions for various EM markets, structurally strong domestic growth, easing rate cycle and geopolitical advantages create potential for increasing exposure to such local and hard currency bonds and rates. We discussed Indian Government Bonds that experts have found to exhibit relatively lower correlations to issuers within other EMs, and less impacted by global factors. The continued domestic economic growth, low foreign ownership in IGBs and recent index inclusion would present a promising investment opportunity over the medium to long term.

Will US Tariffs reduce the US fiscal deficit and avoid govt shutdowns?

It is hard to pinpoint the effect and scale of US tariffs. As much as they can increase the government revenue but can have a negative impact of inflation and productivity (especially on sectors where the balance of trade is severely negative). Yes, an improved fiscal deficit would reduce the chances of a shutdown, purely on government funding matters, but there could also be a political impact in terms of potential deadlock over contentious tariff issues.

In 2016, USD rallied significantly after the elections until year end. However, 2017 DXY fell over 15%. Do you see this repeating?

The USD has experienced significant appreciation throughout 2024, which has made it less attractive against many crosses compared to a year ago. While we do not foresee a repeat of the dramatic 15% decline in the DXY seen in 2017, a stronger USD could indeed counteract the objectives of the Trump administration’s high-tariff policies (hurting the sales of domestic industries and cutting down on their export revenue), suggesting that policymakers may aim to temper excessive dollar strength. In this regard, the yen serves as a valuable barometer. Its recent resilience, marked by an inability to reach new lows over the past four months, could signal broader shifts in USD momentum. Now we are hedging currency exposure both in USD and EUR account.

While there is some uncertainty around Trump’s policy, the US economy continues to outperform. Economic surprises in the US have turned positive as economic data momentum has found a bottom. Thus, the potential here is for growth to shift back in favour of the US, which reinforces the divergence in GDP growth rates between the US and elsewhere since COVID, in line with our view that US exceptionalism is structural in nature. The US is growing, and we expect this to continue through 2025. Against this background, the market is shifting towards a modest Fed cutting cycle that leaves rates in the US higher than elsewhere, helping sustain historically elevated dollar valuations. As such, we expect the USD to continue to strengthen next year.

So do you think it’s time now, to add to some duration?

One of the speakers believes it is the right moment to increase duration. In their multi-asset portfolios, they have been actively adding duration. The 10-year yield is at 4.4%— top decile over the past 25 years— and knowing that the starting yield remains highly predictive of long-term average returns, with a 90% determination coefficient. Further the recent negative correlation between 10-year bonds and equities marks a significant development. This relationship enhances portfolio diversification and introduces positive convexity, offering a crucial buffer in the event of an economic slowdown or a better-than-expected outcome on US fiscal deficit owning to recent nomination at the highest level in the US government.

Further, structural indicators such as the Beveridge curve and CPI continue to trend lower, while real yields—at 180 basis points—represent another 25Y top-decile opportunity. Notably, the 10-year Treasury yield has dipped below pre-election levels signalling reduced market concerns around fiscal deficit trajectories. This shift is likely influenced by the inclusion of prominent figures the Trump administration, which has eased fears of fiscal mismanagement. This backdrop makes the case for adding duration. On a tactical front, they continue to favour US curve steepeners, particularly the 5/30Y trade established a year ago, which remains well-positioned to capitalize on these dynamics.

However, one could take a gradual approach as the key driver of duration’s excess return over cash is the term premium difference between 10 and 2Y rates, currently only 15 basis points (versus a 100bps on average). Between end of 1994 to end 1999, the term premium only average 50bps and 10Y treasury delivered no excess return versus cash over the 5 years periods.

On the other hand, another speaker advises to buying duration when the Fed turns hawkish enough to tighten financial conditions - no cut in December and less cut forecasts going forward. Market is currently pricing some of it (the hawkishness) in the 2y (higher terminal rate), but until we hear from Powell, strong US growth and above target inflation doesn't make long duration very interesting, especially if you have equities in your book. Additionally, the new Treasury secretary Bessent has mentioned normalising UST issuances (current 40% bills vs 60% coupons, guidelines are 20% bills), and the potential increased supply in coupons will be a headwind to long duration.

Is it time to short the CNY given the fact that CNY is likely to continue depreciating?

The Chinese yuan is currently navigating complex dynamics. Economically, a significant depreciation could stimulate growth, like Japan's approach with the yen. However, in a global environment where de-dollarization is gaining momentum, China aims to bolster the yuan's international standing. A substantial devaluation could undermine this objective and affect the government's credibility. Additionally, the United States is likely to oppose a markedly weaker yuan due to trade and political considerations. Given these factors, shorting the CNY may not be the most interesting strategy at this time.

On the other hand, another speaker takes on a more neutral standpoint, adding that shortening the CNY is not unfavourable but calculated risks must be taken. We expect the CNY to continue to fall in the months ahead. Indeed, CNY was always going to be one of the most vulnerable currencies to a Trump win in the US election, though its path would be more controlled due to official smoothing/intervention. China now faces the very real prospect of a ramp up in tariffs, potentially to 60% as Trump has warned. Our analysis shows that such tariffs would result in a material depreciation of the CNY in trade weighted terms. A fall in trade-weighted terms might not be unwelcome given that the CFETS NEER has risen, approaching 100 at present. However, such pressure must be balanced against the potential for bigger China stimulus in the months ahead, following the pivot by China's authorities in late September.

What are some of your additional thoughts on sound fixed income portfolio construction and risk management?

The availability of product today means investors can be more deliberate with the shape of their FI sleeves very efficiently using precision ETFs, index funds or active managers whilst achieving diversification and robustness.

For example, investors can use full curve government bond and credit exposures to gain diversified rate and spread (IG and HY) exposure; they can consider municipal bonds for IG-like yields and Treasury-like quality; use key rate duration or term maturity ETFs for more deliberate positioning along the curve (e.g., laddering out the shorter ends of the curve to mitigate default risk and to lock in higher yields whilst available); allocate to the high yield market via fallen angels (IG issues downgraded to HY) to further mitigate risk in this space; and finally they can diversify not only across quality and duration but also within the capital stack e.g., look at senior secured loans, preferred shares and Additional Tier 1 Capital Bonds.

EM-excluding Asia hasn’t added value for more than a decade, is very risk politically and volatility. Is it really an asset class, why not just buy Asia?

EM Asia Debt has been on an average of 50-60% of the overall EM debt for the last few years and is expected to be in this range for the next year also. The risk profiles of the different regions are quite different. Latin America and Asia defaults are expected to be in a comparatively high range of 3-3.5%, while Europe is expected to be 2.50-3% and Middle East and Africa, below 1%. Among corporates and sovereigns, there are opportunities available, and investors can achieve a diversification within the overall EM allocation by looking at different sectors.

The market environment for fixed income may be more challenging with Trump 2.0 than otherwise, as investors will constantly assess the risks of inflation and growth impact of tariffs and of US fiscal policy. Nevertheless, the consensus appears to be that US rate cuts are still on the table, but it is a matter of how much and how fast or slow. The panel discussed hard currencies versus local currencies allocation. The uncertain macro and monetary policy backdrop will at times present RV opportunities in Asian as selective Asian local currency government bonds have been relatively stable compared to USTs, meaning, on a yield/rate uptrend they may outperform. From time to time, asset swap into Asia LCY government bonds may also provide FX-hedged pick-up which is worth looking into.