Old-Fashioned Bond Math for a New-Fashioned Fed

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GREG HALL: Hey everybody. Welcome to another episode of Accrued Interest, PIMCO's podcast dedicated to serving financial advisors and the wealth community. As always, I'm your host, Greg Hall. I lead the Wealth Management business for PIMCO here in the United States. And once again, I am pleased to be joined by Marc Seidner and Pramol Dhawan. Marc is our CIO of Non-Traditional Strategies.

Pramol sits in New York, here with me, although today he's in our Newport Beach office on the screen with me. And he leads our Emerging Markets investment business. Thanks, guys, for joining us. This is, what, your second time this year and maybe your 10th time overall.

MARC SEIDNER: I don't know if it's the 10th time yet, but it's always good to be with you, Greg.

GREG HALL: Yeah, well, it's enough times. There'll be no excuses for a word out of place or any non-pithy commentary. The reason we've got you on is the reason we always bring you guys on, which is that you've published another in your series of PIMCO Perspectives thought pieces. For those listening, this is a series that Pramol and Marc created a couple of years back.

And the idea was about once a quarter to pepper some of our usual publication schedule with thought-provoking pieces, things designed to help you think through aspects of your portfolio. Sometimes they're tied to hard economic news. Sometimes they're tied to hard portfolio opinions. Sometimes they're just designed to try and get people thinking and make sure that your conversations with your clients are as rich as they can possibly be.

The title of the new piece, which is available now at pimco.com in the US or wherever you gather your PIMCO content, is Old-Fashioned Bond Math for a New-Fashioned Fed. So anybody listening who was tempted to change the channel after hearing bond math, please don't. I promise this is gonna be interesting. Maybe, Marc, I can ask you just to give us the thrust of the piece and let listeners know what they can expect when they pick this up to read tonight.

MARC SEIDNER: Yeah, I think the thrust of the piece was pretty simple, Greg. I mean, I think you and your team get this question a lot. Pramol and I get this question a lot when we're meeting with both wealth and institutionally oriented clients. And the question simply is: Are bond-stock correlations forever altered? Or, is the benefit of fixed income, which is diversification, forever altered?

And a lot of folks, again, we use this phrase in the piece, the muscle memory of 2022 is real, right? I mean, interest rates rose, bonds went down in price, equities went down in price, credit spreads widened, credit underperformed largely throughout the year.

And even since then, I think a lot of folks go and look at moments in time when there were bouts of volatility and periods where stocks and bonds behaved with a positive correlation. The returns behaved with a positive correlation rather than a negative correlation.

And I think that leads many to conclude that this relationship, this benefit of diversification of fixed income, the theme of risk parity, owning a little bit of risk, offsetting it with a little bit of high-quality fixed income or duration, is forever altered. And our point, which is the point of the simple bond math, is we shouldn't, as investors we should care less about brief moments in time and pockets of volatility.

And what we should care about are the big themes, the big risks, the big possibilities, and therefore the big opportunities. And that's the simple bond math, right? I mean, you do the simple math of a 10-year treasury starting at four and a half or 4.6%. And when you need that positive return, it is not inconceivable that you will get a 10% to 20% immediate price appreciation through a decline in interest rates.

And that just takes yields from four and a half to two and a half, effectively, maybe a little bit lower than that to get a full 20%. But that math really works. And that's not an inconceivable scenario. The moment when there's an economic surprise, a financial market surprise, another COVID-like event—not that actually happens—but some shock that none of us are anticipating.

When you worry about the potential for equities to go down 10%, 15%, 20%, 30%, high-quality fixed income can, will—and I mean, "will" is a strong word to say—but I'm quite certain will provide that ballast. They'll potentially give that 10% to 15% to 20% return and offset a lot of those losses. And that's a great thing.

And I think that's what gets lost in the narrative of the market and the dialogue these days: that with the starting point of yields and the simplicity of bond math, in the scenario when you need it and when you want it, that positive return to offset negative potential returns from risk assets will absolutely be there.

GREG HALL: Pramol, maybe I could ask you, because one of the words that you guys use to describe this simple bond math—you use this in the piece, and it came up last week when we had Lotfi on the podcast, who's our Multi-Asset Credit Strategist, and he was talking about private credit and we were talking about AI, but he did venture into this territory.

He also used the term convexity to describe the risk-reward of owning bonds at this moment in time. So maybe you can kind of go one further on Marc's point and talk not just about the potential for benefit if we see declining rates, but also what do you think is embedded in the current levels? How much risk do you see of rates going further higher from here?

And I say this on a day when rates are backing up and people are concerned about inflation and Iran again, so it's not an academic question. But maybe you could just talk a little bit about how the math isn't just straightforward. We think the odds break in our favour in a pretty material way right now.

PRAMOL DHAWAN: Yeah, that's right. I mean, we are approaching this conversation at a time where the 10-year treasury has backed up over 400 basis points since its 2022 low levels. And at a time where Marc and I are doffing our caps a little bit to the new Fed Chair for reinstating credibility.

And I think we all can sometimes be a little bit cynical in markets and critical of policymakers, sometimes fairly so. But I also think it behooves us to take the other side when credit is due, and the Fed spent 20 years building this forward guidance machine—dot plots, calendar-based guidance, balance sheets as a signalling tool. We forget that this is a couple of decades old, and this is not the norm for global central banks.

GREG HALL: Can I pause you? I'd love for you to—I really wanna make sure anybody listening understands. Because I thought the lens that you look through in this piece is really interesting. We're talking about bond math. Nobody should be surprised to hear the bond guys talking about bond math. But you guys chose to look at this problem through the lens of things that Kevin Warsh has pledged himself to kind of dismantling, things that define the last two decades.

So maybe walk us through what we've lived through for the last couple of decades. And then obviously you have some conclusions or some observations about what we might expect. And I'm really curious about the practicalities of investing over the last couple of decades and how you think that might change.

PRAMOL DHAWAN: Yeah. The yield of the 10-year treasury is super important, but it's only as important as the credibility of the policymakers that are backstopping the overall environment. And we start through a lens that this Fed is re-anchoring around inflation, managing inflation, managing inflation expectations. And let's not forget that that's super important in the history of bond and equity returns.

The best returns in equity markets come during periods of credible central banks. That's why we care. So when we talk about these terms of yields or term premiums, we are really stating these numbers because we think there's a chance of realizing the coupon and realizing some price appreciation. That is not the case if you do not have a credible monetary authority. Those numbers are just numbers which tend to keep going up as the market describes more and more term premium.

So first and foremost, yes, it's an ode to the starting levels of yield, but really it's more than that. It is reinforced against the credible targeting of inflation. And when those two powerful forces hit together, really you can start to realize the bond math that Marc has spoken about. And that bond math is just very, very powerful right now.

And in steady states of the world, you are realizing your coupon, you may get some appreciation, and it's certainly in a high-quality portfolio, which can extend to high-quality credit. You can clip this sort of potential 6% to 7% steady-state-type returns.  That's the environment that we're seeing this year.

Still sort of half of the calendar year to go. But it's really in that asymmetric downside situation where growth can curtail, you sort of get to peak AI exuberance, inflation—we start worrying about it on the other side of the ledger. And really in that scenario, the benefit of bonds, something that people have forgotten about a little bit in this AI exuberance, will start to kick back in again.

And when we think about quadrant math, in three states of the quadrants, bonds do really well, and in one state they don't do very well. Really the state of the world that they don't do too well is the state of the world where the term premium is increasing because of lack of credibility.

And Marc and I are saying, well, that's also being truncated at the same time as well. So look, we feel that people do need to start to think about rebalancing.

GREG HALL: So that's the convexity point that we started down this path with, which is that what's embedded in yields at these levels is maybe some room to go even higher. You can't rule it out, but there's a lot of appreciation for the inflationary state of the world we've been living in for the last few years, maybe a lot less appreciation for the deflationary effects of AI.

The robots take over, they're hosting this podcast, and you guys are talking to an empty screen, and I'm out of a job. And so there's the potential for deflation as well. And that doesn't seem to be captured in market levels, I think is the argument that you're making. And if it plays through, I think an advisor who's very bullish on the AI scenario could actually find his way to being very bullish on his bond portfolio as well.

MARC SEIDNER: Yeah, yeah. Greg, let me just add to that, right? I mean, as you said, here we are, a group of bond managers, and I've spent the better part of my career arguing for bonds and against equities, and I don't think that's what we're trying to do here. I mean, if I was an advisor, I think it'd be very hard to argue against equities because there is enough that's transformational that's taking place in the world.

I do think we have to be very concerned about valuation. But there are plenty of scenarios, just as Pramol has talked about, four quadrants. There are plenty of scenarios where equities continue to do exactly fine given resilient growth and the like.

And if we do have a more credible central bank, or Federal Reserve, which we think we do—not that it lacked credibility—but Kevin Warsh has, I think, really impressed since he's taken office and we can certainly talk about that.

It's not an argument against equities. It's an argument for risk parity. It's an argument for diversification. What if we said to the average advisor, well, take as much equity risk as you want. In fact, maybe take more. But what if we gave you something that helped your portfolio against potential drawdowns in case there are unexplained events, unintended consequences, uncertainty goes up?

And that can come from a variety of areas, whether it's geopolitics, whether it's the true economy, whether it's financial shock or surprise. But the point isn't that own bonds instead of equities. It's own bonds as a complement to equities. And don't rely on the fact that this muscle memory of '22, don't rely on the fact that a simple analysis is of why bonds went down in 2022.

So they're not gonna be able to do their job. In the past, from this starting point of yields, it's kind of unambiguous to us that you can do both. You can have both. And in fact, that's what you want to structure your portfolio for.

And by the way, given the starting point of cash rates, and that cash rates, again, will likely continue to go down, the market is romancing, debating whether the Federal Reserve raises rates 25 basis points by the end of this year because of the knock-on effect of rising energy prices and the risk of second-round effects, and the resilience of the economy. That argument matters less. That argument matters much less because it's fully priced in. And then the question will be, well, when you need it, will it work?

The phrase we use is, it's time to exorcise the ghost of 2022. And again, I think that does mean that there are portfolio alternatives that can provide really nice returns across a wide range of scenarios because you don't have to worry so much about your bond risk in a reasonable range of outcomes. Many of which, when equities do very well. And then if you do get that surprise shock or the negative scenario, then you have that balance, that ballast. And that's our point. It's not bond geeks against equities. It's bond guys trying to help with prudent portfolio construction.

PRAMOL DHAWAN: Have both. Have both. And you're getting paid which is the difference between 2022, which is, it's really hard to say that when you had a 2% tens, right?

MARC SEIDNER: My goodness. Real yields on inflation-protected bonds were minus 1.2% in 2022. You were paying the government to safeguard your money. Now, the real yield on that same TIPS is 2.3%. I mean, as Pramol said earlier, a four-percentage-point differential and a whole bunch of different reasonable outcomes in terms of performance and return.

GREG HALL: Well, let's talk a little bit about the Fed. You guys have mentioned Warsh a couple of times now, and we're a few months into the Warsh Fed. What is the principal difference between his approach and what he inherited?

PRAMOL DHAWAN: We don't know what we don't know. It's very, very early so far. We can sort of say that he's bought a call option on credibility. That call option was priced at zero in the market, and he bought it, and quite rightly so. He's re-anchored inflation expectations.

There's this notion that the Fed hasn't been at target for five years. Some would argue it hasn't really been close to target for five years. And he's put that back front and center of his thinking, of the committee's thinking. And I think that's only good for bonds, only good for markets, only good for the US on a longer-term basis and history has shown that.

We don't know about how the task forces and the interaction of the task forces are gonna work with the FOMC. We still have to wait and see on that. But I think the initial reaction from our Investment Committee is this is good. This is good for financial assets. It's good for bonds.

MARC SEIDNER: Pram—

GREG HALL: Oh, I'm sorry. Go ahead, Marc.

MARC SEIDNER: I was just gonna say, I won't, I try to repeat too much of what Pramol said, but I think there is this concept of the Warsh dividend.

GREG HALL: Yeah, you use that in the piece. I like the phrasing.

MARC SEIDNER: Yeah. And it's this idea that he comes into office and he asserts himself as independent. He is credible in terms of his inflation-fighting resolve. He's skeptical about the activism of the central banking community over the last 15 or 20 years. And that skepticism, I think, is about forward guidance and repression of volatility and communication more broadly.

And he's critical of some of the past practices. And I think that opening up to introspection is extraordinarily healthy. And I think our sense is that that will re-anchor inflation expectations, which could very well be quite positive for interest rates in the intermediate to longer term, whether it be neutral levels of short-term interest rates or how steep curves should be, your term premium.

There will be an element of reform, which is great because it lets markets set prices rather than central banks set prices. And, as we've said on this podcast many times before, full disclosure, we're biased. We're active managers, and we want environments that are quite positive for active management across all of our disciplines.

And if you have less repression and more volatility, where markets actually have to do their own work, or investors have to do their own work, rather than just listening to every word that comes out of central bankers' mouths and assuming that that's gonna be the outcome, then that creates a much more interesting environment for alpha generation, and a heightened degree of uncertainty premium creates greater opportunities to reposition portfolios. That gets folks like Pramol and I out of bed pretty early in the morning with a spring in our step and a glimmer in our eyes.

GREG HALL: I think it's very interesting in that I'm not sure—I mean, I think people listening generally get the direction. Warsh has been very public about this, his belief that the Fed overcommunicates, that in the past—you guys probably have more academically appropriate terms for things like this—but giving the market the cheat code on where rates are headed and he's gonna leave it a little bit more to the market's own devices, not try to create outcomes.

And I would imagine that might lead to some surprises, that might lead to some volatility, that might create a bumpier path. I think it's very interesting the way that you argue in the piece that the market's confidence in his willingness to endure that may actually smooth the long term. But we may have a little bit more near-term movement.

And then you follow up with the point, which I think is interesting as well, which is movement isn't bad. Movement is the opportunity to take profits, change position, find something else. Obviously, get things wrong—we get things wrong all the time, right? Our results are the sum of our wins and our losses. But a much more fertile field, if you will, to find interesting investment opportunities.

PRAMOL DHAWAN: Maybe if we explore the counterfactual here, Greg. What if they didn't withdraw forward guidance? What if that was the forward expectation almost in perpetuity? Well, now you have a potential Bank of Japan-type scenario where you are trying to control every aspect of your yield curve. And you find that you can't walk away from markets.

You can't allow markets to stand on their own two feet. And we've seen more recently, how hard it is, how difficult it is for them to be able to walk away from the scenario. The last two decades have been extraordinary, and certainly we don't want to disparage what previous governors did. They did what they did at a time which was acute difficulty coming out of the Global Financial Crisis, again with COVID.

The need for some guidance in markets was clearly there. But we are past those times now, and we have reset to normal levels of interest rates. So I think it's only fair to applaud this notion of saying that the markets can stand on their own two feet. They can absorb the volatility. They don't need the Fed to do that on their behalf. And that, over time, is going to be good for our ability to extract risk premium in yield curves.

GREG HALL: Is there, should we—and maybe this is too philosophical and, we try to be practical on the podcast—but is there an interpretation of this moment as maybe a final realization that, 20 years past the Financial Crisis, we're ready to let markets do what they do best and that we're out of intensive care, we're out of observation? And while we don't expect—I don't know how far to take the medical analogy here—we don't expect Warsh to abandon his rounds, we're left to kind of heal on ourselves.

MARC SEIDNER: Yeah, I mean, I think that's right. I think it's free-range markets.

GREG HALL: Free range markets.

MARC SEIDNER: And it is true, it's incumbent upon investors to do their work, right? Because that safety net might be there. But the proverbial central bank put is probably slightly further out of the money than it has been in the past. And again, that's a good thing. We debate in Investment Committee a ton whether or not this will lead to a higher vol regime. That tends to be my view.

I think it's Pramol's view. But I think it also depends on what your time horizon is, right? If the Federal Reserve is credible in its inflation-fighting resolve, if it is credible in its use of monetary policy, if it's less reliant on the communication strategy and it is reform-minded, it may lead to a higher uncertainty premium, but not necessarily more volatility, which might lead to steeper yield curves, which might lead to wider credit spreads, which might lead to higher implied volatility in the options market.

And that's fine because, in fact, we'd welcome that environment because that's an environment where we can harvest perennial excess risk premium. Whether it's rolling down the front end of the curve, whether it's capturing credit spreads that are reasonably priced versus where they are today, which seems excessively rich, whether it's being able to trade optionality within the market to capture intertemporal movements.

So this doesn't necessarily mean higher volatility, doesn't necessarily mean that markets are gonna move around a lot more. It just means that risk premium might be elevated, and that's a very healthy environment for active investors and for alpha generation.

GREG HALL: Yeah. But to your earlier point, the risk premium most of our advisors are most heavily exposed to, of course, is the equity risk premium. And that's, again, a place to just be mindful in your portfolio.

MARC SEIDNER: It gets back to the point, right? I mean, this is not either/or. This is an "and."

It's a very healthy environment. And again, if you go back to periods in time through history where there had been elevated risk premia, it's a great environment to compound wealth, and we should all be excited about it. It's just how do you structure it, I think you should structure it differently today than you might have thought about it over the last five years.

And that can also be a public market versus private market comment as well. And it really is just a reinforcement of perhaps the balanced portfolio or, as I've said, or as we've said before, the concept of risk parity.

PRAMOL DHAWAN: I also think one thing that we talk a lot about in Investment Committee is it's not just the yield, Greg. It is the diversification possibilities around fixed income in a world where we are starting to see more of a narrowing of the distribution in the Mag Seven in the US, TSMC in Taiwan, Samsung in Korea; very, very large mega-cap stocks dominating equities and equity indices.

Fixed income really offers that ability to globally diversify. And the yields that Marc spoke about can be amplified with high-quality selected developed markets, high-quality emerging markets, supplementing treasury ballast to the portfolio as well. And that can certainly enhance the yields as well.

GREG HALL: Well, I think it's a really timely piece. I was mentioning to you guys before we started here that we've been doing a lot of research on the average advisor portfolio in the US. And we're lucky to operate in a space where there's a lot of data available, and we can slice and dice and look at things a bunch of different ways. It wouldn't come as a surprise to anybody listening.

It won't come as a surprise to you. The degree to which the typical investor in the US is now 80%, 90%, 95% allocated to equities at the expense of virtually everything else in the portfolio. At the higher end, you see some alternatives exposure as a diversifier. But really, who can blame them? Over the last 10 or 15 years of financial repression and low interest rates, you've seen fixed income dwindle as an allocation.

And I think you're making a really strong case here for reconsidering that, pursuing balance. And I think we just ask anyone listening who's interested in that thesis, interested in implementation—we know it's not easy to think about appreciated stock and the tax consequences of trading in order to rebalance, so none of that is lost on us, but there are strategies you can use to bring your portfolio into closer balance. And of course, we're always happy to talk about those.

We'll probably feature that as a topic on a dedicated basis on a future podcast. I just wanted everybody listening to get the full benefit of Marc's and Pramol's viewpoints on this piece. Encourage everybody to come to the website and take a look at it.

If you identify yourself as a financial advisor, you'll be taken to Advisor Forum, which is the one-stop destination we've set up for you to get what you want from PIMCO as quickly as possible and to get on with your day of meeting with your clients and helping them through these markets. If you enjoyed today's presentation, I'd be remiss if I didn't ask you to hit Like and Subscribe.

If we know you're out there, it helps us continue to bring great content to you. And I think Marc, Pramol, and I all wish you luck in the markets. We hope that we've provoked some thought here, and we're happy to answer any questions you've got on the follow-up if you'd like to be in touch with us. So thanks, guys. Appreciate you always being here for us.