Wall Street week ahead: Bond fund managers see risk Fed cuts rates to zero

Speculation the Federal Reserve will continue cutting interest rates well past its policy meeting next week is pushing some bond fund managers into assets ranging from short-term Treasury bills to half-paid off 15-year home mortgages. They're betting that short-term US interest rates will once again return to near zero for the first time since the wake of the 2008 financial crisis.

The market is already pricing in a 93.5% chance the US central bank cuts short-term interest rates by at least 0.25% at its October 30th policy meeting, according to CME Group's FedWatch tool, continuing a rate-cutting cycle that began earlier this year and helped lead to bull markets in both bonds and equities. The probability of such a cut was just 64.1% in late September.

Yet fund managers and analysts from firms including First Pacific Advisors, Columbia Threadneedle, and Brandywine Global say the market is still underpricing the possibility the Fed will continue cutting rates well into next year, essentially taking short-term interest rates back to where they were before the central bank began lifting rates in 2015. "We think the Fed's precautionary cuts continue and the market isn't anticipating that scenario and is priced for a soft landing next year," said Edward Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle.

As a result, shorter duration Treasurys up to 2-year bills are becoming more attractive, as well as emerging market bonds that are priced in dollars, he said. "We're looking for opportunities to add in risk assets that are sensitive to US rates," he said, expecting gains will come more in the form of price appreciation than yields.

The Fed's likely efforts to steepen the yield curve by continuing to cut rates past the market's expectations will also make short duration high yield debt attractive, said Gary Herbert, head of global credit at Brandywine Global, an affiliate of Legg Mason with $75 billion in assets under management. "There's a higher probability of a recession than we thought at the beginning of this year, and the Fed may need to return more significantly to unorthodox monetary policy like quantitative easing," he said, referring to the bond-buying program the Federal Reserve instituted as an emergency response to the financial crisis. "It's not unthinkable to expect a recession in the next year, it's one stupid tweet away."

At the same time, Herbert is buying investment grade corporate bonds that mature in approximately 3 years. He is focusing on companies such as Boeing Co and General Electric Co that have strong balance sheets yet are struggling due to issues including a corporate turnaround and the grounding of the 737 MAX airliner. "Even if they were to be downgraded, they would be able to tender that debt to create better liquidity," keeping their strong balance sheets intact, he said.

Tom Atteberry, portfolio manager of the $7.3 billion FPA New Income fund, said negative bond yields in Europe and Japan are prompting more foreign investors to pick up US debt, which will continue to push yields lower throughout the market.

He is finding opportunities in bonds backed by prime-rated auto leases, loans for equipment ranging from cell phones to service fleets, and 15-year mortgage pools that originated in 2012 and 2013, he said. Each category offers yields between 1.90% and 2.25%, compared with the 1.73% yield the benchmark 10-year Treasury offered Thursday, and should continue to do well if interest rates fall.

"You should have higher yields, but you've got two large economic blocs with negative yields and central bank interventions on an ongoing basis," he said. "It's almost an unnatural time."