Beware the Consensus
A year ago bond yields were moving up materially and reached multi-year highs. Economists were racing to put up the highest number on their yield forecast for 2019 while financial advisors were fielding constant questions about potential losses from their clients’ fixed income portfolios. Once again the consensus was wrong in the financial markets. Not only did the Bloomberg Barclays Aggregate Bond Index post a positive gain amid the fear, but in fact completed the best rolling 12-month stretch since 2012. If we cherry-pick the top in yields, the eight-month gain of 8.7% is the second-largest since 2001. Just as in 2016, when yields bottomed, we are starting to see an uptick in firms lowering their 10-year yield forecast below the current rate in a race to the bottom.
The large gains are attributable to an unusual circumstance where corporate bond spreads were tightening even as Treasury yields were falling. Usually spreads widen when Treasury yields make a sharp lower move given a large percentage of buyers that are yield focused. The recent rally in corporate bonds could set up a “pain” trade as most active managers are underweight in the space, especially BBB-rated bonds, given the narrative of excessive debt levels and downside economic scenarios. We continue to overweight BBB-rated bonds partly due to a favorable convexity, i.e., they gain more on the upside than they lose on the downside. We have been overweight BBB-rated bonds for several quarters.
Corporate spreads have exhibited significant volatility in the past year, and we have been fortunate enough to generally be on the right side of these actions. Following a tactical underweight in May that saw corporate bonds underperform Treasuries more than 1.25%, we upgraded the space to neutral with an overweight bias in early June. We continue to limit exposure to longer-dated corporates, which has been a tailwind to performance and helps alleviate some of the risk from the overweight to BBB-rated bonds. It does appear we are at a crucial threshold regarding corporate bonds. Either downside economic scenarios start to unfold or the large percentage of investors that have de-risked will be forced to buy back in at higher prices as forward-looking economic indicators improve. We will objectively follow our models and expect to outperform should either scenario unfold, although this could be associated with slightly higher than normal turnover levels.
The Federal Open Market Committee (FOMC) essentially adopted an easing bias at their June meeting. Seven of the 17 members who put out fed funds forecasts expect a cut of 50 basis points before the end of the year. Federal Reserve (Fed) Chair Jerome Powell started off the press conference by making it clear the Fed will do everything possible to extend the economic cycle. The Fed is now clearly saying they will support the market, a complete U-turn from the rhetoric in December. Despite these comments from Chair Powell, it still appears many members remain reluctant to cut rates unless the data worsens. This defeats the point of a pre-emptive cut. It makes it more likely when cuts do arrive, it will be too late to ward off the self-reinforcing economic downturn.
We very recently shifted our outlook on duration from overweight to a new underweight. This is driven by the excessive move in yields prone to a retracement along with some pickup in early growth indicators. Despite this, we expect the headline data to get worse before it gets better. We are closely monitoring the leading indicators for evidence they are rolling over. This would greatly improve the likelihood the Fed is behind the curve and warrant a return to an overweight duration.
Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet.
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