Rethinking Rates, Inflation and Duration

VOICE-OVER: Welcome to Fixing Your Interest.

Today’s episode takes a closer look at bond markets at a time when yields have reset higher, central bank expectations are shifting, and geopolitical uncertainty is growing.

Mohit Mittal, PIMCO’s CIO of Core Strategies, joins economist Peder Beck Friis to discuss the compelling yield opportunity, how investors should think about duration positioning, and what could drive inflation and policy from here.

They also explore the growing impact of AI on markets and where they see the most attractive opportunities across global fixed income today.

PEDER: Mohit, welcome to London. Great to have you on the podcast.

MOHIT MITTAL: Thanks for having me.

PEDER: You've obviously been at the firm for a long, long time. You're part of the firm's investment committee. You manage a number of our big portfolios for our clients.

I want to start with a very big-picture question to you. We just published our secular piece, our secular forum. Two years ago, the title of it was The Yield Advantage. This time we say that the yield advantage, or that yield, looks even more compelling now than it did two years ago. So I want to start there. Why does fixed income look so much more attractive today than a few years ago? And what role do you think fixed income plays in global portfolios going forward?

MOHIT MITTAL: Yeah. I think the reason the backdrop is so much more attractive today is the generational reset higher in yields that we saw in 2022. So for context today in the UK-oriented investor can get a high-quality fixed income portfolio yielding 6% to 6.5%. That is very, very high quality, you know, AA-plus type of rated exposure that is globally diversified.

And then importantly, those starting yields are a really good indicator of forward-looking returns when you look at it with a three- to five-year horizon.

Second is that, you know, the opportunity to add alpha has increased quite significantly in the portfolios as well. You have shifted from an environment where yields and term premiums were suppressed by global central bank policies around QE.

You're seeing a shift away from that. You have this huge diversification or bifurcation that is gonna get created because of AI. That will create disruption, that will create opportunities for active investors. And then the geopolitical backdrop creates further opportunities as well. So net of it, starting yields look quite attractive, alpha opportunity set looks quite attractive, which makes the backdrop quite attractive for fixed income investors.

PEDER: Perhaps it shouldn't be a big surprise to hear that a fixed income shop like PIMCO likes fixed income.

MOHIT MITTAL: Yeah.

PEDER: But of course, this is all also reflected very much so in our portfolio positioning. Now we are overweight duration or what's called the exposure, the sensitivity to interest rate risk in our portfolio. So what's driving that positioning and that sort of duration overweight in that portfolios?

MOHIT MITTAL: Yeah. So I think that duration overweight is stemming from what happened with the yields post the beginning of the Iran war in early March. And the context is that when you look at how the markets evolved, markets started to price in inflationary outcomes, which is not a surprise in  the near term, one would expect inflation to move higher.

This is what we expect as well. However, where we differ slightly is how long this inflation can persist. And our thinking is that, you know, higher inflation, particularly when wages are not keeping pace with inflation growth, means that there's a scenario where demand starts to slow down. And hence, the inflation may not be as persistent, particularly in countries like the US, for example, or even in Australia as well. So that's the first aspect.

The second aspect is that we are also sitting at a very different picture or environment as far as the consumer savings rate, as well as the jobs market, is concerned. Jobs market today, you don't have as many open jobs for the number of unemployed as we had in 2022. And then the savings rate today is much lower than what it was in 2022. So that also reduces the flexibility that consumers have to spending as prices go up on energy.

And, against that backdrop, what you have seen is the repricing in yields. And I think you are an expert on that. I welcome your perspective also on that. But what we saw, for example, in the UK was that we shifted from almost two rate cuts priced in at the beginning of the year to two to three rate hikes getting priced in over a span of short order for the next six months. In the US, we went from, again, a couple of rate cuts to up one hike by the end of this year.

So these are possible outcomes. We just think it'll be a little bit more difficult to achieve rate hikes in this environment given the growth backdrop that this higher inflation is creating.

PEDER: Yeah.I think that's the good point around inflation. Certainly, this will create inflation, is already translating into high spot inflation in the US and in Europe. And of course, we can debate the magnitude around where it will peak.

MOHIT MITTAL: Yep.

PEDER: But I think where we have stronger conviction is around this fact that this is a very different macro backdrop to back in 2022. And I think there's a perception among, to some extent, policymakers, but market participants, that in 2022 it was Russia invading Ukraine that sort of triggered the inflation surge back then, which is not true.

Of course, inflation was already above target, accelerating before Russia invaded Ukraine. And I think the big difference today really versus back then is the fiscal backdrop.

MOHIT MITTAL: Yeah.

PEDER: Remember back then we had, you know, many years of very expansive fiscal policies, certainly during the pandemic, you know, money printing, fiscal deficits. That certainly led to very strong household balance sheets.

MOHIT MITTAL: Yeah

PEDER: In turn led to very strong labor markets. And fast forward to today, you know, the situation I think is very different. Fiscal policy certainly has not been as expansive. Labor markets are weaker, perhaps not weak in all countries, but they're certainly weaker than back then. And I think that reduces the chances, the likelihood, that we'll get what central banks refer now to as second-round effects.

You know, this energy shock will lead to lasting effects on inflation expectations and wage growth, etc. And again, I think, to my mind at least, speaks to reducing the likelihood, as you mentioned, that central banks will deliver all the hikes that's priced into the front end of the curve. So perhaps that's a good segue..

MOHIT MITTAL: Yeah. I think one of the differences that I would highlight now relative to 2022 is the starting level of yields, So at that time, if you recall, we were operating with extremely low central bank rates across the globe.

Whereas right now, as we were talking about earlier, when you have a starting yield of 6% to 6.5% in a high-quality fixed income portfolio, you have ample cushion for an outcome that is somewhat higher inflation than what was previously anticipated.

So I think that's another big difference that gives investors a cushion to a scenario where inflation might persist for somewhat longer.

PEDER: And of course, a higher starting level of yields from a monetary policy point of view means that in many countries going into this shock, central bank monetary policy was tight in some countries, very different to back then. So perhaps that's a good segue to speak a little bit more about the central bank outlook.

We touched on the fact that we don't expect a lot of the central banks to deliver the hikes priced into the front end of the interest rate curve. But, you live in the US, based in Newport Beach. I follow the Fed, of course—but you follow the Fed with a closer distance.

So why don't we start with the Federal Reserve? We've seen, as you mentioned, pretty sharp repricing in the expectation of the Fed. So how do you think about the Fed outlook over the next year and beyond?

MOHIT MITTAL: Yeah. So I think the first and foremost will be that any new Fed chair, when they take on that position, they're expected to be some changes. And I think we need to be kind of open-minded about what that might be. A lot of talk has been about Kevin Warsh adjusting the communication policy.

I think possibly that can happen. So we might see somewhat reduced communication.

Kevin Warsh has also talked or underplayed the role of the dots. So we might see some shifts there. I think the likely course of action for the Fed would be to keep rates on hold until you get more clarity on the data. And I think the variable we would watch is the policy around balance sheet.

PEDER: One central bank that has hiked, well, the first large central bank to hike in response to the US-Iran friction has been the ECB last week. Hiked 25 basis points to 25.

And I think in Europe, again, similar to the US, we have seen a sharp repricing of expectations of central bank policy rates going forward. Historically, of course, central banks tend to look through these energy shocks. If oil prices go up, central banks can't really bring oil prices down.

MOHIT MITTAL: Yeah.

PEDER: They can't solve the shock, the oil frictions in this case. But clearly central banks now seem to be much more worried about inflation expectations de-anchoring.

MOHIT MITTAL: Yeah.

PEDER: And this, of course, to some extent reflects the fact that inflation has been so long above target that we've seen a much more hawkish central bank reaction function. But I think similar to you, in Europe we would be surprised if the central bank delivered the hikes that's priced into financial markets. Bank of England here in London, you know, certainly there are risk cases in which they would hike.

MOHIT MITTAL: Yeah.

PEDER: But the modal expectation very much is that it will remain on hold going forward. And the ECB may, you know, it's possible they hike one more time, but certainly we would not expect this to translate into a long hiking cycle going forward. But let me ask you this, Mohit. I mean, this is, you know, at PIMCO we focus a lot about baseline, but we spend almost most of our time in terms of scenarios.

Yeah. So, suppose we come back in a year's time here, we have a podcast, you and I, and, you know, the central banks or the ECB, for instance, would've hiked four or six times.

MOHIT MITTAL: Yeah.

PEDER: You know, how do you think we would've ended up in that scenario? What are the risks that we are monitoring on the upside?

MOHIT MITTAL: So I think if we come back in a year and the ECB would have hiked four or six times, the likely driver would have been a little more persistent inflation.

PEDER: Yeah.

MOHIT MITTAL: And so I think that's the first thing that we've been monitoring quite carefully. And then, you know, the variable that we would focus on is the second-order effects from energy. You know, clearly energy price shocks impact Europe more.

You know, on that front, at least in the near term, some de-escalation with respect to the US-Iran war certainly helps. But the second-order effects become very, very important to monitor. So that's what we've been kind of focused on with the help of you and the rest of the team here in Europe.

PEDER: We touched a little bit on inflation, and I want to take a little bit of a big-picture view on inflation because, you know, as active fixed income managers, as our listeners can hear, we debate inflation a lot.

This is a key input, of course, into the monetary policy reaction function. But if you just zoom out since the pandemic, inflation has been high for a long period of time.

MOHIT MITTAL: Yeah.

PEDER: In some countries it was sort of back to target before the war, Europe being one of them. But if you take the US, it really has been above target now for, I think, five years, the longest period since the start of the inflation-targeting regime in the US. So, how worried are you around persistent inflation? How do you think about the secular outlook around inflation in terms of your portfolio positioning?

MOHIT MITTAL: I think there are a few drivers that can keep inflation above central banks' 2% target over a secular horizon. So, you know, in the near term, you have this massive AI CapEx that is happening. Now over the medium to long term, any new technological development has a huge productivity boost.

If AI was to deliver on that productivity benefit, then that's a disinflationary force. But in the near term, because of that CapEx, which over the next five years is expected to be $5 trillion just on the AI side, add to it energy, it does provide an inflationary impulse, at least in the near term.

Add to it the defense spending and then probably also a little bit around the deglobalization or the replication of supply chains to have more manufacturing closer to the demand center in the US.

So they have an inflationary impulse into the system. What does that mean to us? That inflation over the next three to five years could be more than central banks' target? Absolutely. Maybe in the mid to somewhat, you know, 2.5% to 2.75% inflation relative to central banks' 2% inflation target.

Now, there's also another scenario where inflation comes down faster. And that is, you know, certainly AI-related productivity benefits. It could also be downward revisions to growth scenarios, which are also possible if AI CapEx was to slow down.

So those would be scenarios where inflation can come down towards central banks' target of 2-ish percent. As bond market participants, we want inflation expectations to remain well anchored.

And so that's certainly a good thing. And then I think the last thing I would say is that because of all these inflation concerns, there is a risk premium that is now embedded in the bond market. So the term premium has steepened, real rates have gone higher.

So if you look at, for example, you know, 10-year real rates today in the US, they're north of 2%, almost 2.25% area. So you have that real rate that is compensating you for potential future inflation that is higher than central banks' targets.

PEDER: I think one of the big lessons for me since the start of the pandemic is how remarkably anchored inflation expectations have been around the targets.

Even though inflation reached double digits in many countries during the pandemic throughout this entire episode, and even now, of course, in response to the US-Iran war, forward-looking inflation expectations have been very anchored around 2%. Perhaps risks around that.

But I mean, to me at least, that speaks to a tremendous amount of credibility to central banks. It's a good reason why long-term yields have remained so anchored. So I want to shift the conversation a little bit to the second big shock that's happened this year. The two big shocks I would categorize are the geopolitics.

MOHIT MITTAL: Yep.

PEDER: That's been clearly a driver of certain parts of the asset market. The second big one, which has been surprising many, has been AI.

MOHIT MITTAL: Yep.

PEDER: And you mentioned this earlier. How do you think about AI, the impact of AI from a portfolio construction point of view? And then, of course, if you have any thoughts on macro as well, I'm happy to have a conversation around that. But from a portfolio construction point of view, how do you think about AI?

MOHIT MITTAL: Yeah. So I think, as you mentioned, kind of a lot of things happening on that front. So I think the way to first think about it is there's a huge amount of CapEx that is going on in order to fund that AI infrastructure.

So from a portfolio construction point of view, it's important to recognize how that CapEx is funded. A big portion of that CapEx is being funded in the debt markets.

PEDER: Yeah.

MOHIT MITTAL: So we have to kind of be prepared for this deluge of supply in the debt markets. We have to be very selective on that front. You know, our framework has been that outcomes with respect to AI are anything but deterministic. And it's not clear where on the stack the final ultimate value will go to. Like, will it go to the bottom of the stack with respect to the chips?

Will it go all accumulated at the data center level? Will it go to the frontier models, or will it go to the application layer on top? So we have to recognize the uncertainty around that. And hence, as bond investors, our focus is to protect the downside. You know, while recognizing that we don't enjoy the upside as much. As an equity investor, you know, you can certainly benefit from one or two trades that go extremely right, whereas as debt investors, if we do multiple trades and one of them doesn't work out, that is incredibly negative for our portfolio returns. So we have to be very careful on the downside.

So our focus has been strong focus on the collateral that we are getting, the documentation, the covenants, the residual value from the lessor and who the ultimate lessor is when we are acquiring these data center deals. So we are seeing a lot of these deals. We are very selective.

We have seen some very good opportunities in this environment of winners and losers that will get created.

PEDER: Yeah.

MOHIT MITTAL: So that's the first aspect. The second aspect is AI's impact itself, and that impact itself can be quite disruptive. You know, many of the legacy businesses can be negatively impacted. So we have to be mindful as we think about our portfolios, which businesses can be exposed should AI achieve its promise.

So certainly software space, consulting, servicing space can get negatively impacted. So we've kept the exposures light or underweight in those sectors that we believe could get disrupted because of AI.

PEDER: Back to portfolios. We spoke about fixed income being attractive. Starting level yield is attractive. Alpha opportunities are attractive. We like being overweight duration or interest rate risk. But where across the fixed income, markets do you see the most compelling opportunities right now?

MOHIT MITTAL: Yeah. I think a few of them. One is a little bit around global diversification. So I think when we look at fixed income markets, we are seeing interesting opportunities in high-quality government bonds in the US, in the UK, in Australia, in Japan for the first time in decades, in Japan for example.

So a little bit around global diversification in high-quality government bonds. Also included in that are certain EM countries like Brazil, like Chile. And the rationale there is that the real yields are meaningfully higher than in the DM world. And then the fiscal backdrop is more benign relative to the excessive fiscal spending that EM countries saw during the COVID period.

So, you know, that's the first layer of portfolio construction. Second is around higher-quality spread products. Interesting opportunities there. We talked a little bit around AI infrastructure needs. That is creating some opportunities. But even beyond that, you know, financials still look interesting.

Areas outside of corporate credit, for example, agency mortgages, structured products, that has been an interesting source and still looks attractive in the portfolio context.

Having a little bit of inflation protection through Treasury Inflation-Protected Securities, or more so globally inflation-protected securities, is another opportunity across our portfolios. A little bit around currencies. Our view is a modest dollar underweight.

We think the dollar maintains its strong reserve currency status but can depreciate a little bit from here on based upon current valuations. And hence, having a little bit of currency diversification in the portfolios.

And then finally, also focusing a lot more on the idiosyncratic opportunities that get created every now and then. We saw, with respect to the US-Iran war, opportunities in the Middle Eastern sovereigns that got created. So we focused in the months of March, April, and May on the opportunities in the Middle Eastern sovereigns that looked interesting.

So net to us is, you know, lot of interesting opportunities to add a little bit of excess alpha relative to already high initial fixed income yields and thereby create an equity-like return profile with much lower volatility and a much higher Sharpe ratio relative to what investors can get in equity risk.

PEDER: Yeah. So lots of opportunities across all markets, really, it sounds like. You mentioned the US dollar and our view on the US dollar. You mentioned that we don't think the US will lose the status of global reserve currency.

And we've obviously spoken about this. These have been long debates. They were perhaps more intense last year than this year. But that brings me to the US debt outlook.

MOHIT MITTAL: Yeah.

PEDER: As one of the first questions I tend to get in my client conversations as a fixed income investor is particularly US debt sustainability. We've all seen these charts with US debt trending higher, the fiscal deficit stuck at a very high level, and there doesn't seem to be much willingness in the current administration to tighten fiscal policy. So does that worry you, the US debt outlook in the context of the investments that you're making in your portfolios?

MOHIT MITTAL: Yeah. So I think you said it well, right? There is no desire on either side of the aisle to have lower fiscal deficits in the US. Is that a concern? It is a concern. But it is not something that will come to a head-on realization in the near term.

And I think the context there is that the US fiscal deficit is, give or take, 6% to 7%, and the nominal growth is around 5%. So you have a backdrop where debt to GDP will go up by about 1% to 1.5% per year for the next five years. And that is certainly something that the US reserve currency status allows it to do because of the demand that still exists for US government debt.

So the area where it becomes a concern is the lack of ability to address future recessions because of the existing debt profile of the US. Right? To just give some context, right? In 2007, before we entered the GFC, the US debt-to-GDP ratio was, give or take, 35%.

When we exited the GFC, the US debt-to-GDP ratio went from 35% to 70%. Then from 2010 to 2020, the US debt-to-GDP ratio grew by about one percentage point per year, went from 70% to 80% by 2020. Then from 2020 to 2022 to address COVID, we increased it from 80% to 105%.

And now we are on a trajectory where we'll keep increasing it by 1% to 1.5% in a normal time when growth is strong. Let's imagine a scenario where there is a recession in the next three to five years. We just don't have the ability to increase debt to GDP by 15% to 20% to address that next recession.

And I think that's what needs to be also incorporated when we think about the risk premium that we need in equity and in credit markets because those have benefited from massive fiscal spending over the last 15 years as well.

PEDER: Yeah, that's a great point, and I think one that's not really overlooked by many investors. You know, in a typical recession, even without active fiscal easing in the US, you could see a deficit falling to 10% or something like that just from non-discretionary measures in the US. So that obviously limits active fiscal easing.

But the good news is, even though fiscal space is limited, we have much more monetary policy space. And I think it's interesting to compare before the pandemic because then the tables were always turned. Remember, we had much more fiscal space, no monetary policy space because interest rates were so low.

Now it's the opposite. Very limited fiscal space, and of course, given the starting level of yields that we've spoken about, much more room for central banks to cut. And of course, that has implications for asset prices.

The other thing I want to tag on, and we just finished our secular forum, debt sustainability in the US is always a big topic that we speak about. And we debate scenarios: how do we end up in these scenarios? But we always tend to land that a fiscal crisis in the US strikes us as unlikely.

MOHIT MITTAL: Yeah, no problem.

PEDER: Partly because of the US dollar.

MOHIT MITTAL: Yeah.

PEDER: But also the one that I tend to come back to is the fact that the tax burden in the US is lower than the rest of the world. There's no willingness to raise taxes in the US, but if you went back to the same tax burden under Bill Clinton in the 1990s, then the deficit would be cut in half. And then suddenly I think investors wouldn't really debate the debt sustainability point as much.

MOHIT MITTAL: And I think one other point on that front also is that the positive scenario is that we realize the productivity benefits from AI.

PEDER: Yeah.

MOHIT MITTAL: The US will be the biggest beneficiary to growth. That will be a real growth.

PEDER: Yeah.

MOHIT MITTAL: And that will help bring down deficits as well because real growth is what is needed to have a lower deficit. It creates income, and that allows for not just more taxation, but also it helps increase the GDP. That is the denominator in the debt-to-GDP dynamic.

PEDER: That's right. Okay. So lots of discussion points. We've spoken about central banks, inflation, AI, debt sustainability, portfolio positioning. But let's bring it all together for our listeners here. So what does it all mean for investors, in particular in fixed income, going forward?

MOHIT MITTAL: I think what it means for investors is that you need to think about an environment where the fragmentation of what we had previously highlighted—geopolitics, financial markets, trade—is accelerating, and it's creating a lot more bimodal and fatter-tail outcomes.

So if you have that kind of distribution over the next three to five years, one needs to think about where can you get the best risk-adjusted returns in that kind of a fatter-tail environment.

Higher-quality fixed income can be that anchor where, under most states of the world, as we talked about, based upon initial yields, you can get that 6% to 7% across a range of outcomes. So that's the first important point.

And then again, because of so much that is happening that we talked about, it presents interesting opportunities to add excess return above and beyond the passive benchmarks because of the liquidity that fixed income offers. And then active management can take advantage of that liquidity.

PEDER: Okay. Well, thanks. Fascinating discussion. We'll wrap it up here. We should do this more often by the way.

MOHIT MITTAL: Absolutely.

PEDER: You should come to London, and we should record one every time you come over. But thanks to you and, of course, thanks to our listeners for tuning into this episode.

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PEDER: Mohit, welcome to London. Great to have you on the podcast.

MOHIT MITTAL: Thanks for having me.

PEDER: Very excited for this podcast. The plan is hopefully we'll have a good conversation around markets, macro, investment views more broadly. You've obviously been at the firm for a long, long time. You're part of the—

VOICE-OVER: Thanks for joining us on Fixing Your Interest as we explored what higher yields and a changing macro backdrop mean for bond investors today.

Stay with us as we continue to navigate the challenges and opportunities across fixed income markets.

For further insights, analysis and resources, visit PIMCO.com.