The interest-rate outlook remains firmly in investors’ sights at the start of 2024. When will rates come down? Switzerland could be the first to move, while—on the back of successive economic data releases—the market consensus continues to push the Federal Reserve’s pivot out toward the spring. Markets are pricing infive to six rate cuts for 2024.
After displaying surprising resilience in 2023, the US economy is expected to achieve a soft landing over the course of the year. The labor market remains robust; wage growth is slowing, but still at levels sufficient to support consumer spending. At the same time, corporate balance sheets and cash flows remain solid.As for inflation, while the easiest part of the journey is already behind us, it is expected to continue trending down toward the price-stability range, i.e. around 2%.
That said, the USA’s soft landing might turn out to be not so soft after all. That could happen ifthe delayed effects of higher interest rates were to weigh more heavily on activity—particularly if rates remain elevated for too long—or if fiscal support were to be sharply curtailed. And there are also geopolitical risks and the US presidential election.
So what rate-cut scenario should investors expect over the coming quarters? Markets are currently betting on a rapid easing cycle. However, stronger-than expected employment data or more persistent inflation would push out the likelihood of Fed action and provide renewed momentum to 10-year US Treasury yields. Renewed volatility in bond yields is entirely normal in a soft-landing scenario. By contrast, an excessively rapid decline in yields would signal a move toward recession.
If, like the market, you are convinced that US rates will be cut before the summer and are looking to monetize that view, structured products can provide solutions. The choice of underlying is crucial, as it allows investors to capture volatility premia in addition to the directional move in rates.
To benefit from both the expected decline in interest rates in 2024 and their elevated volatility, one option is to use a long-dated US government bond ETF invested in maturities of 20 years and above—as the underlying for a structured product. That type of ETF would provide leveraged exposure to long-term rates via its long duration
What type of structured product suits this strategy? A reverse convertible allows the high volatility of the long-duration underlying to be transformed into guaranteed coupons equivalent to nearly twice the typical yield offered by long term USTreasury bond ETFs.
This approach offers investors not only partial capital protection against an adverse scenario of rising rates, but also potentially favorable tax treatment. If US rates follow the central scenario of declining or remain at current levels, the investor receives a guaranteed coupon and full capital repayment at maturity. Should rates rise unexpectedly, the investor is still protected against an initial decline in the ETF at maturity before taking physical delivery of the underlying ETF.
If you are more cautious about the consensus scenario and concerned about a potential deterioration in the geopolitical environment—one that could unexpectedly trigger a renewed rise in rates or a widening of credit spreads—a capital-protected product with participation in a bond underlying (for example, the same ETF as above) may be an attractive alternative. If the base case materializes, the ETF’s performance would be amplified by its long duration. Conversely, if the underlying were to fall due to rising rates or widening spreads, the downside would be neutralized by the capital protection.
Another strategy in periods of shifting interest-rate dynamics is to invest in a product designed to capture the steepening of the yield curve—that is, the relationship between yields on longer-dated and shorter-dated government bonds.At the end of 2023, the yield curve was described as inverted (see chart), with short-term rates higher than long-term rates. A rate cut by the Fed would mechanically narrow the gap between short- and long-term yields. In such a product, performance depends on the flattening or steepening of the curve: it offers capital protection at maturity plus a multiple of the measured steepening, for example as reflected in the spread between the 10-year and2-year government bond yields.
Depending on your convictions, these different positions can be used to diversify portfolios beyond the direct impact that interest-rate movements have on equities or bonds.
The spread between 10-year and 2-year US government bond yields reached record levels in 2023.
Vincenzo Bochicchio
Responsable du développement et du trading des produits structurés
TRANSLATED AUTOMATICALLY, WITH LIGHT EDITING OF THE TRANSLATION BY BCV. ONLY THE ORIGINAL FRENCH IS AUTHORITATIVE.
