Calamos Fixed Income Suite: Why Conditions Call for More Defense

Matt Freund, CFA, Christian Brobst, and Chuck Carmody, CFA

Summary Points:

• We believe a soft landing or stagflation is more likely than negative nominal GDP growth.
• We continue moving to slightly more defensive positioning regarding industry exposures and credit qualities, reflecting our expectation for softening consumer activity, slowing growth and inflation above the Fed’s target.
• Long rates may not benefit from Fed cuts as much as history suggests; our core-plus mandates are positioned with durations shorter than their respective benchmark index but longer than their average peer. CIHYX’s duration is shorter than that of its peers and benchmark.

A proactive Fed surprised the market in September by cutting its overnight lending rate by 50 basis points rather than the 25 basis points the market expected for weeks following Chairman Powell’s Jackson Hole appearance. It did so in the face of surprisingly strong GDP growth, a resurgence in business investment, and consumer activity that remains robust. One could argue that the Fed’s decisive cut was particularly unexpected given the soft-landing narrative that had gained steam through the quarter.

Service PMIs are well above 50, growth is still above trend, and consumer sentiment is consistent with levels of 2020 and 2021 when Covid stimulus was most impactful. We mentioned in our 2Q Outlook the tailwind that immigration and the resulting US population growth has brought to consumption and sales statistics, and we point to that dynamic again this quarter as having a powerful impact on a broad range of activity measures and consumer-related company earnings announcements alike.

As always, there are pockets of weakness to highlight. Labor markets softened and moved into closer balance; unemployment claims rose gently; and the unemployment rate crept higher, reflecting job losses and people being added to the labor force. Meanwhile, manufacturing endeavors are contracting, although the rate of deterioration is shallow.

All this resulted in an environment where the Fed felt comfortable delivering its first rate cut since 2020. The committee sees the neutral rate of interest (r*, that which neither aids economic growth nor restricts it) around 2.9%. If correct, that would leave even the resulting 4.875% target rate quite restrictive. And given the lag with which changes in policy rates impact economic activity, the Fed is likely trying to skate where the puck is going, as opposed to where it is. Often, easing cycles have a more immediate effect than hikes. However, with 80% of consumer mortgages locked into rates of 5% or below, we believe the Fed has considerable wood to chop before reaching a level of rates that will stimulate consumer demand.

In its statement, the Fed indicated that risks to employment and price stability are now roughly balanced. If it is being intellectually honest about the exercise, balanced risks would imply that the committee wants to be much closer to the neutral rate. This objective introduces the problem of figuring out what r* actually is. We will learn what the neutral rate is as the Fed cuts and we approach it, but for now, we are taking the cautious view that neutral is somewhere between 2.5% and 3.5%.

As it has done repeatedly in this cycle, the market is pricing in more aggressive easing than the Fed’s estimates. At the beginning of the year, futures markets priced in a hefty seven cuts to the fed funds rate in 2024, then shifted to expectations of no cuts during the early part of summer. Following the 50-basis points cut in September, the market now sees eight additional cuts through year-end 2025, with a terminal funds rate of 2.8%, agreeable with the long-run Fed dot.

One of the most surprising developments of the quarter was the unanticipated vigor in corporate revenue and EBITDA. For the first time since 2021, companies in leveraged finance markets saw both measures improve year-over-year versus levels in 2023 when the fed funds rate was at its 5.5% peak. Still, there are pockets of weakness, and idiosyncratic risk is a critical factor to evaluate correctly for performance.

Positioning Implications

Fundamentals and a more dovish Fed seem to indicate that a soft landing can be achieved, and we are gaining confidence that negative nominal GDP growth is becoming less likely, especially in light of population growth. But credit spreads are priced to perfection, and we are using the market opportunity to position Calamos portfolios slightly more defensively.

Based on what market pricing is telling us, we are re-evaluating some of our investment theses and have moderated risk by migrating credit quality higher and increasing our weights in more defensive sectors. As we expect consumer activity to soften, we have reduced below-investment-grade holdings in the airlines and retail industries. If spreads widen to where we believe we are being well compensated for the risk, we will look to re-enter some of these recent sales.

As we noted, futures markets are pricing an additional eight rate cuts before year-end 2025. While the Fed’s projections drag those eight cuts out to 2026, expectations for the terminal rate are similar between the market and Fed policymakers. Our team sees the odds of a soft landing or stagflation as equally probable and more likely than recession. In either case, we believe growth moderates and inflation remains above target, led by housing prices, because of the definitive and growing shortage of units.

We believe the interest rate implications for either scenario are similar: a rate-cutting cycle that fails to deliver what the market has priced. As such, we want to be positioned with shorter durations than our peers. However, peers have extended durations significantly longer than their benchmarks. Our core-plus mandates (Calamos Total Return Bond Fund and Calamos Short-Term Bond Fund) are positioned in the middle ground—with durations longer than their benchmark but still short of peers, as we anticipate the Fed will be challenged in cutting as many times as the market and committee project. Calamos High Income Opportunities Fund is positioned with a duration that is shorter than both its benchmark and average peer, although interest rate sensitivity in the high-yield market is a smaller driver of risk and return.