Fixed Income Strategist: Turning the tide
After hovering around zero for the past 10 years, central bank tightening pivots have pushed 10-year US Treasury yields to 1.94% in the fourth quarter of 2019; 10-year German Bund yield at 0.04% (first positive yield since 2019); and Japan’s 10-year yield at 0.17%.
As a result, the amount of negative-yielding debt securities in the Bloomberg Global Aggregate Index has fallen from $14.1 trillion on December 21st to just $4.8 trillion on February 7th. Although foreign sponsorship continues to constrain higher US interest rates, interest rate volatility will remain a focus in 1H22 until the market gains some more certainty about the aggressiveness of the Federal Reserve’s radical swing in March, which would create market inefficiencies. wider spreads and a more desirable opportunity for fixed income investors.
In this issue of Strategist, we discuss our outlook on interest rates, the yield curve and changes to our current positioning. We are slowly adding sectors that have drastically underperformed in the face of the sudden turnaround in sentiment, such as preferred stocks, rather than sectors that have outperformed their credit alternatives, such as CMBS. We maintain a bearish view on real and nominal interest rates and maintain a preferred weighting of senior bonds versus 10-year Treasuries, although we are trimming this allocation slightly from 6% to 5% as interest rates have risen. Given the normalization we’ve seen in nominal Treasury yields – with 5-year Treasury yields at 1.79%, a July 2019 high, and 10-year at 1.94%, a December 2019 high – we think so that any further rise will be less abrupt and less abruptly impacted by fixed income capital flows, while credit spreads should continue to benefit from strong economic fundamentals.
View of the tariffs
The market is pricing in over five rate hikes in 2022, and the 34% probability of a 50bp hike in March has flattened the 2-year/10-year curve by over 30bps since the first week of January, when the 2nd – to 5-year range has taken the brunt of rising interest rates. Given this dovish outlook, our least favorite part of the curve – the 5-year, ie the belly – returned about 1.79%, up over 100 basis points since September.
We have long held a negative attitude toward the belly of the curve. While we believe 5-year yields have the potential to move slightly higher given the Fed’s and market’s dovish expectations, we are now leaning towards a neutral view on 5-year nominal yields as we approaching 1.8%. However, we remain negative on 5-year real yields, which are still elevated at -1.01% and expect to trend towards -0.25% by year-end. Given the 100 basis point rise in nominal 5-year yields that took place in less than four months, we believe the rise in real yields is being driven by the decline in break-even inflation expectations as current 5-year inflation expectations are at 2.8% is towards the Fed’s 2% target by the end of the year as the market moves further away from peak inflation.
Since the beginning of 2022, there has been a large exodus from bond funds. $11.6 billion exited bond funds for the week of February 2nd, the largest weekly outflow since March 2021. We expect this knee-jerk reaction to ease in the months ahead. Investors who focus on the fear that rising interest rates will lead to near-term declines in bond markets may lose sight of the biggest risks in their portfolio. Investors should manage their interest rate risk without eliminating it entirely. Reducing interest rate risk too much—either by shortening duration excessively or increasing credit risk excessively—can increase the risk of your portfolio. We remain bearish on interest rates – a view we have held since May 2020 – and believe 10-year yields will reach over 2% in the coming months. However, headwinds from US Treasury underperformance will be less of a drag on overall performance in the coming months.
We invest opportunistically in those sectors that have faced severe performance headwinds since global central banks turned the page on monetary policy accommodation. However, we expect vulnerabilities as we begin a new chapter marked by fewer shelters and tighter financial conditions.
Principal Responsible: Leslie Falconio, Senior Fixed Income Strategist
For more information, see February’s Fixed Income Strategist: Turning the page.