Fixed income strategist: Turning the page

After hovering around zero for the past 10 years, hawkish central bank pivots pushed 10-year US Treasury yields to levels of 1.94% in 4Q19; The 10-year German Bund yields 0.04% (the first positive return since 2019); and Japan’s 10-year yield at 0.17%.

As a result, the amount of negative-yielding debt in the Bloomberg Global Aggregate Index fell from $14.1 billion on Dec. 21 to just $4.8 billion on Feb. 7. Although foreign sponsorship remains a constraint to higher U.S. interest rates, until the market gains some more certainty about the aggressiveness of the Federal Reserve’s hawkish pivot in March, rate volatility Interest rates will remain a focal point throughout 1H22, which would lead to market inefficiencies, wider spreads and a more desirable set of opportunities for fixed income investors.

In this issue of The Strategist, we discuss our outlook on interest rates, the yield curve and changes to our current positioning. We are slowly adding sectors that have significantly underperformed amid the sudden shift in sentiment, such as preferred stocks, instead of 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 to senior loans over 10-year Treasury bills, although we are reducing this allocation slightly from 6% to 5% as interest rates interest increased. Given the normalization we have seen in nominal Treasury yields – with the 5-year at 1.79%, a high in July 2019, and the 10-year yield at 1.94%, a higher high in December 2019 – we believe any further rise will be less abrupt and consequent to fixed income flows, while credit spreads should continue to benefit from strong economic fundamentals.

Rate Outlook

The market is pricing in more than five rate hikes in 2022, and the 34% chance of a 50bp hike in March has flattened the 2y/10y curve by more than 30bps since the first week of trading. January, as the 2–5-year region took the brunt of the interest rate hike. Given this hawkish outlook, our least favorite area of ​​the curve – the 5-year area, i.e. the belly – reached around 1.79% yield, an increase of more than 100 points from basis since September.

We have long adopted a negative position on the belly of the curve. Although we believe that 5-year yields have the potential to rise slightly given hawkish Fed and market expectations, we are now moving more towards a neutral view of nominal 5-year yields as we approach 1.8%. However, we remain negative on the 5-year real yields which, at –1.01% are still rich and anticipate a trend closer to –0.25% by the end of the year. With the 100 basis point rise in nominal 5-year yields, which has occurred in less than four months, we believe that the rise in real yields will be driven by lower equilibrium inflation expectations, as current trends in 5-year inflation expectations of 2.8% towards the Fed’s 2% target by the end of the year, with the market moving away from peak inflation.

There has been a major exodus from bond funds since the start of 2022. For the week of February 2, $11.6 billion exited bond funds, their largest weekly outflow since March 2021. We expect this instinctive reaction lessens over the months ahead. Investors who fear that rising rates will cause the bond market to decline in the short term could lose sight of the main risks in their portfolio. Investors should manage their interest rate exposure without eliminating it entirely. Reducing interest rate exposure too much, either by excessively shortening duration or by excessively amplifying credit risk, can increase the risk in your portfolio. We remain bearish on interest rates – a view we have had since May 2020 – and expect 10-year yields to hit over 2% in the coming months. However, the headwind from underperforming US Treasuries will have less of a negative impact on overall performance in the months ahead.

Conclusion

We opportunistically allocate sectors that have faced severe headwinds since global central banks turned the page on political accommodation. However, we expect pockets of vulnerability as we enter a new chapter defined by less accommodation and tighter financial conditions.

Lead Contributor: Leslie Falconio, Senior Fixed Income Strategist

For more, see the February issue of Fixed Income Strategist: Turning the page.

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