Is It Time to Favor a Long Duration Bias?
August 22, 2023
Long maturity Treasury yields surged higher in the past month due to concerns over increased auction sizes, a credit downgrade by Fitch for U.S. government debt and the bond market pricing out the possibility of an imminent U.S. recession. The bear market in Treasuries has been driven by a surge in real yields, while inflation expectations have remained well-anchored; for instance, the 10-year inflation breakeven rate (2.34%) is largely consistent with the Fed’s 2% target. Presently, the U.S. 10 Year Treasury is yielding 4.20%. In conjunction with falling inflation expectations, the 10 Year long-term real rate is now at 1.86%, marking its highest level since 2009.
We believe high real yields are at sufficiently restrictive levels to impact the real economy. The constraining stance of U.S. monetary policy is substantiated by the deeply inverted yield curve, the contraction in the money supply, and the tightening in credit conditions. Consequently, the high real yields already reflect peak Fed hawkishness. As we approach the end of the Fed’s tightening cycle the landscape is becoming increasingly appealing in terms of extending the duration or interest rate sensitivity in fixed income portfolios. From an asset allocation perspective, the bond risk-adjusted return profile has improved relative to stocks.
The bulk of the investor community has now embraced a ‘soft-landing’ or ‘no-landing’ scenario for the U.S. economy. However, a weaker 2024 U.S. economic growth scenario is plausible as U.S. household excess savings deplete, the U.S. fiscal thrust wanes and the lags of monetary policy impact the credit cycle. Consequently, a backdrop of low inflation will likely drive expectations of a shift toward easier Fed policy. Therefore, signposts for a mild 2024 U.S. recession and a labor market cycle suggest more aggressive rate cuts than currently factored by the bond market.
Investors remain very bearish on bonds, with a stretched short positioning. This can potentially serve as a catalyst for a bond rally as we look ahead into 2024. Lastly, tightening credit conditions pose a headwind for corporate credit and, on the margin, we expect fixed income investors to lean on sovereign debt for relative safety.
DISCLOSURES AND DEFINITIONS
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Asset Allocation does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.