Fixed Income sprinted off to a good start this year in January (+3.08% for the Bloomberg Aggregate Bond Index). This was driven by the assumptions that disinflation is taking hold and the Federal Reserve would lead the economy to below trend growth this year as it approached to the end of its rate hike cycle.
But hotter than expected inflation and jobs data in February caused bonds to reverse course (-2.59% for the Index) and cast some doubt on these assumptions. Has the positive view on fixed income changed? What if some or all of these original assumptions turn out to be wrong? What proactive fixed income positioning can be implemented to account for the risks to the market consensus?
At ALPS Advisors we use a simple, unbiased framework: the yield curve progression cycle. It primarily helps ascertain what economic regime is currently priced in by market participants (i.e., expectations). But, more importantly, as short-term movements deviate from the natural progression, the cycle can offer some basic positioning insight to prepare for ‘tail risks’ to the market assumptions.
Typical Yield Curve Progression Cycle
The typical cycle begins in Quadrant 1 (top left) with a normal upward-sloping yield curve shape, and moves clockwise through the yield curve regimes. In the end, the yield curve, through policy actions and the economic cycle, tends back to its normal state. However, there can be significant humps and inversions along the way, which are viewed as transitional. The current yield curve, with its front end hump and abnormal deep inversion in the belly of the curve is a good example of a yield curve in transition.
Important Framework Considerations:
- The Federal Reserve’s current policy directives determine the initial regime, the level of short term rates and a projected rate path (Quarterly Federal Reserve Summary of Economic Projections (SEP) which contains the “Dot Plot”).
- The Market Participants determine the rest of the yield curve’s shape, which is always a forward looking view in an attempt to anticipate the next regime and stay “ahead of the curve” and capture excess returns.
- The typical relative outperforming sectors generally apply during the current yield curve regime. Forward looking market regimes have typical relative outperforming sectors that apply heading into that regime.
- The yield curve progression framework only makes the following assumptions: (1) That the yield curve is always working towards normalization and (2), market pricing is neither correct nor incorrect.
While it may seem obvious that yield curve progresses neatly around this clock, it is not uncommon for different scenarios to quickly develop. For example, over the past five years we have experienced two compressed rate cycle regimes in the time it normally takes one to be completed! The table nearby illustrates potential forward-looking economic scenarios that could develop over the next year.
Where are we?
The current regime, set by the Fed, remains in the Restrictive/Inflation fighting Quadrant 1. However, based only upon the typical cycle progression from this current scenario, the market’s forward looking view would be bullish for fixed income, as the inverted yield curve sits between the “soft” and “hard” landing regimes. Both these regimes favor longer duration, Treasury securities and high grade fixed income.
But similar to the wrong assumptions on inflation at the onset of this restrictive rate cycle, what assumptions in 2023 could cause the clock to speed forward to the more bearish scenarios and pose as a ‘tail risk’?
Some examples could be the market or the Fed:
- Underestimating the possibility for a reigniting of inflation (i.e. sticky is far stickier than previously thought and is getting embedded in wages and rents).
- Underestimating the embedded growth potential of the global economy and strength in labor markets.
- Underestimating the impact of Federal Funds rate hike transmission through the economy, when in fact Real Rates are the driving force and are still very low by historical standards.
Conclusions from the Yield Curve Framework – Stay Invested, Flexible and Protected
As of this writing (3/1/2023), the yield curve progression framework suggests that investors stay fully invested in fixed income, but to seek additional yield with higher quality credit, such as Investment Grade Corporate and Municipal securities. The current yield curve is abnormal and transitional, which portends a high degree of volatility and uncertainty.
In this case, the framework supports a “barbell” approach to consider ‘tail risks’ to the consensus forward view. This approach entails overweighting at the short end of the curve (to remain flexible and still earn above average yield in a “higher for longer” scenario) and overweighting the long end of the curve (which could offer considerable protection should the “hard landing” scenario develop). Actively-managed short duration and long government provide methods to create a “barbell” allocation.
A key attribute of active management is the ability to challenge the market consensus. The consensus can and does change when the market gets sufficiently actionable information. The Fed’s next formal rate path projection, which is due out later this month, will contain new data along with a number of assumptions, such as the projected short term rate path, rate of inflation, unemployment, and GDP. As new data informs new projections and assumptions, our yield curve approach provides a dynamic framework to enable effective yield curve positioning and the potential for attractive risk-adjusted returns.
Important Disclosures & Definitions
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
One may not invest directly in an index.