Kathy Jones: The Bull Case For Bonds, And The Need For “Caution” on Private Credit & Leveraged Loans

Episode Summary

Executive Summary: Kathy Jones argued that the bond market’s recent surge in yields was driven mainly by a stronger-than-expected U.S. growth/inflation rebound, not Treasury supply. She expects slower growth, disinflation, and eventual Fed cuts starting around mid-2024, favoring intermediate-duration Treasuries, investment-grade corporates, and selectively munis, while remaining cautious on loans, high yield lower quality, and private credit.

Main Topics: Bond market volatility and the October-to-November reversal (Priority: 5/5): Jones explained that the sharp rise in yields in September-October was largely a reaction to unexpectedly strong growth data and rising rate expectations, while the subsequent November rally reflected a return to slower-growth, disinflationary conditions. Fed path: disinflation first, cuts later (Priority: 5/5): Her base case is continued inflation decline, with the Fed likely starting rate cuts around June 2024 and cutting three times by 25 bps, though she allows that a mild recession could accelerate easing. Duration positioning and yield curve outlook (Priority: 5/5): Schwab favors gradually adding duration, especially intermediate maturities around six years, and expects the curve to remain inverted with 2-year yields likely rangebound while 5- and 10-year yields can grind lower. Treasury supply, term premium, and market drivers (Priority: 4/5): Jones pushed back on the idea that Treasury issuance is the dominant driver of yields, arguing that markets largely anticipate supply and that the bigger forces are growth, inflation, and the Fed reaction function. QT, liquidity, and bond market volatility (Priority: 4/5): She said continued quantitative tightening alongside rate cuts may be mechanically awkward and a source of market stress, especially given reduced Treasury market liquidity. Credit opportunities and risks (Priority: 4/5): She prefers investment-grade corporates and some munis, but is cautious on bank loans, leveraged loans, and private credit because of late-cycle credit deterioration, opacity, and refinancing risk. Global rates and FX: Europe, Japan, and the dollar (Priority: 3/5): Jones sees developed-market yields falling, with Europe potentially easing before the Fed, Japan remaining a special case due to BOJ normalization and hedging costs, and the dollar retaining some upside if the U.S. outperforms growth-wise.

Key Arguments: The autumn selloff in bonds was primarily a reaction to a surprisingly strong U.S. growth burst and higher inflation/rate expectations, not just Treasury supply. Inflation has already fallen substantially and should keep easing as goods prices, import prices, wage growth, and labor demand soften. A recession is not required for yields to fall, but it remains possible because policy tightening, QT, tighter bank lending, and weaker small-business credit all slow demand. The Fed is unlikely to cut as aggressively as the market expects because officials remain cautious about reigniting inflation. The 2-year Treasury may be too rich versus the Fed path, but the 5- to 10-year sector still has room to rally as disinflation and lower policy rates work through the economy. Term premium should probably fall from elevated levels, though it is difficult to forecast and could remain noisy if policy uncertainty persists. Treasury supply is real but usually anticipated; issuance shocks matter at the margin, but supply is not the main statistical driver of yield moves. QT and rate cuts together may be hard to calibrate without creating liquidity problems or a market accident. Mortgage-backed securities remain cheap, but not at extreme levels; convexity and prepayment uncertainty argue for caution. Investment-grade corporates and select munis offer attractive income with better risk-adjusted appeal than lower-quality loans or private credit. Leveraged loans and private credit carry late-cycle refinancing, covenant, and transparency risks that many investors may be underestimating. Europe may cut before the Fed, which could pressure the euro and support the dollar; Japan remains distinct because currency hedging alters the yield pickup calculus.

Data Points: 10-year Treasury yield peak: 5.02% - Jones said she views 5.02% as the cycle peak for the 10-year. 10-year Treasury yield around interview time: ~4.17% to 4.25% - She referenced current yields in the mid-4% area after the November rally. PCE inflation headline: 3.0% YoY - She cited the Fed’s preferred inflation measure on a holistic basis. Core PCE inflation: 3.5% YoY - She noted core inflation has fallen steadily from its peak. Expected inflation path: 3.5% to 2.5% in 2024 - Her forecast for further disinflation into 2024. Expected Fed cuts in 2024: 3 cuts of 25 bps each - Schwab’s base case for Fed easing. Likely start of Fed cuts: Around June 2024 - She said cuts would probably begin mid-year, not in January or March. Small-business hiring share: 75% to 80% - She used this range to explain why tighter credit conditions matter for labor markets. Import prices decline: 8 months in a row - Evidence of disinflation in the goods sector. Market-implied terminal rate mentioned: ~3.3% - Jack referenced market pricing for the lowest expected Fed funds rate. Neutral real rate assumption: ~1% - Jones’ framework for estimating fair value for rates. Long-run 10-year fair-value range: 3.5% to 4.5% - Her rough valuation band using neutral rate plus inflation and a term premium cushion. Corporate bond yields: 5% to 6% - She said investment-grade corporates looked attractive at these yields. Municipal tax-equivalent yields: north of 5% - For high-tax-bracket investors, especially in places like New York and California. Threshold for foreign investors in U.S. bonds (example): Japan-to-U.S. hedged pickup can turn negative - She noted currency hedging can erase the attractiveness of U.S. Treasuries for Japanese buyers.

Pivotal Quotes: "We think that we are on our way to achieving that 2% inflation over time." — Kathy Jones: Her core macro thesis: disinflation should continue, supporting lower yields. "Rocky Road, lower yields, but Rocky Road in 2024." — Kathy Jones: Her shorthand for the year ahead: bullish on bonds, but expect volatility and uneven price action. "I think it will, yeah, go down. I think negative is a possibility, particularly if we hit a recession." — Kathy Jones: On term premium, she expects some decline and allows recession could push it lower.

Implications: Listeners should expect lower yields over time, but not a smooth move. Intermediate-duration quality bonds look attractive, while lower-quality credit and opaque private credit deserve caution. Policy surprises, liquidity, and global central-bank shifts remain the key risks.