Still a Bumpy Road for Fixed Income
Core fixed income returns were negative in the second quarter, further exacerbating the largest drawdown on record.
• The Ice BofA US Master Index is down 4.6% in the second quarter
• The Ice BofA US Master Index is down 10.4% year-to-date
• Investment grade corporate bond spreads are much wider in second quarter
• Investment grade bonds underperformed Treasuries by about 4.5% this year
Improving Fundamental Case for Lower Yields
The technical backdrop on Treasuries is quite negative given they are in a clear downtrend regarding price. We tend to favor assets more when they are demonstrating some form of an uptrend. It is often a high risk to low reward going overweight assets in downtrends. Offsetting the negative technical picture is a bullish fundamental backdrop for higher Treasury prices and lower yields. The economic data is no longer slowing due to base effects, but the underlying trends are deteriorating quickly. This, combined with a Fed reaction laser focused on a lagging Consumer Price Index (CPI), creates good odds the Fed will over-hike. This drives recession, slower growth, lower inflation, and lower bond yields across the entire curve.
However, plenty of wild cards remain:
• What will quantitative tightening do to yields?
• Will Japanese yields crack higher (pulling global yields higher) as currency dynamics unfold?
• What is the impact of the U.S. Dollar ending June with its highest monthly close in 20 years?
• Will European sovereign risk change the global fixed income landscape?
We moved to a neutral duration stance in mid-June as the fundamental backdrop improved and provided a more balanced story regarding duration risk.
Betting on the Tails
As we move into the second half of the year, it appears that the probabilities of tail outcomes have increased. The Fed can continue to hike into a slowing economy and create further wealth destruction. This should bring inflation expectations much lower and prevent a repeat of the 1970s. Long bonds should act well in this environment, and this remains our base case at this time.
Another very plausible scenario is the Fed attempts to engineer a soft landing. Even though they appear to be way behind the curve, cutting rates ahead of CPI falling would at least show they are forward looking and want to protect employment on equal footing with inflation. This will likely be celebrated in the market via a steeper Treasury curve and roaring equity prices (assuming they are pre-emptive and not chasing mounting job losses). This scenario will certainly look good at first, but what happens when we begin a new cyclical upswing with inflation starting at 4-5%, oil prices north of $100/ barrel, and record gas prices? This is what led to the crisis in the late 1970s. Is the Fed thinking this far ahead?
We think the Fed will remain hawkish longer than most expect, opting to extinguish inflation and excessive speculation (cryptocurrencies as an example) as long as the markets provide a somewhat orderly drawdown. This should help stabilize long bond yields because they are hiking into a weakening economy. Corporate bond spreads remain vulnerable. We reduced credit risk toward neutral several months ago and continue to hold existing positions. Corporate bonds continue to have high transactional costs and it is sometimes better to express a more defensive posture by increasing duration via Treasuries as we did in the month of June. Treasuries have tremendous liquidity and offer great optionality to alter duration with minimal friction. This is the primary reason we favor a high allocation to Treasuries in our strategies.
Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet, Refinitiv.
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