Day Hagan Smart Sector® Fixed Income Strategy Update August 2024
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Day Hagan Smart Sector® Fixed Income Strategy Update August 2024 (pdf)
Risk Management Update
The Catastrophic Stop model combines time-tested, objective indicators designed to identify high-risk periods for the equity market. The model (Figure 1) held steady during July and entered August with a fully invested allocation recommendation.
Figure 1: Catastrophic Stop Model vs. S&P 500 Total Return Index
Fixed Income Sector
US 1-3 Month T-bill
US 3-7 Year Treasury
US 10-20 Year Treasury
TIPS (short-term)
US Mortgage-Backed
US Floating Rate
US Corporate
US High Yield
International Corporate Bond
Emerging Market Bond
Outlook (relative to benchmark)
Neutral
Neutral
Neutral
Underweight
Neutral
Underweight
Overweight
Neutral
Neutral
Neutral
Fixed Income Commentary
In July 2024, the U.S. fixed-income market displayed a diverse performance. Bond yields rose initially due to higher inflation but later decreased as growth and inflation stabilized, creating a positive environment, especially for higher-quality bonds in the municipal sector.
The Federal Reserve's policy stance and expectations of future rate cuts, along with improving economic conditions, significantly impacted yields. Despite concerns about potential risks, the outlook for fixed income remained cautiously optimistic. Looking ahead, given the manageable levels of inflation, there is a potential for the Federal Reserve to cut interest rates, making bonds more attractive. Although all-in yields across fixed-income sectors remain attractive, it is crucial to exercise caution regarding below-investment-grade risk due to tight spreads. Tax-exempt credit still offers room for spreads to tighten, and higher-rated municipal bonds continue to hold considerable value.
The market is indicating a turning point in the economic cycle, which has historically favored higher-quality bonds. However, a prolonged period of restrictive policy rates poses a risk to vulnerable fixed-income segments. Overall, while the risk of a near-term downturn is low, it is imperative to monitor policy rates and market conditions closely.
Yields in July were influenced by several factors. Firstly, the Federal Reserve's policy stance and the market's expectations of future rate cuts played a significant role. Even though the Fed did not make significant changes to its rates, the slowing down of inflation to more manageable levels opened up the possibility of future rate cuts, which improved the prospects for bonds.
Secondly, the economic backdrop showed signs of easing, with financial conditions improving and private sector balance sheets remaining strong. The resilience of the U.S. economy, strengthened by fiscal programs and corporate fundamentals, also supported the fixed-income market. Despite concerns about potential tail risks, such as global economic uncertainties and geopolitical factors, the overall outlook for fixed income remained cautiously optimistic, with attractive yields across various sectors.
Additionally, there is a slow-motion G7 easing cycle underway. US Treasuries typically anticipate easing cycles, with 10-year yields falling before Fed easing. This scenario might cause financial conditions to ease, especially if the need to hedge duration in MBS leads to further purchases of Treasuries as yields fall. Easing financial conditions during the risk rally reduces pressure on the Fed to ease but complicates policy-setting.
Figure 2: Broad-based Central Bank Rate cuts are constructive for bonds.
Sector Commentary
U.S. Treasuries: Our comments from last month continue to hold true, “The composite model rates inflation expectations as disinflationary, with momentum measures, equity market trends, and U.S. Swaps as neutral. The U.S. Citi Economic Surprise Index turned negative in early May and has continued to retreat lower, indicating that economic reports over the past three months have been coming in below expectations. This has spurred discussion around a “soft landing” rather than “no landing.” A soft landing would be constructive for fixed income.” Measures of momentum, equity trends, swap extremes, and inflation expectations are supportive. We continue to focus on the short to middle area of the curve.
Figure 3: Inflation expectations continue to move lower. Bullish for bonds.
TIPS: We are currently underweight TIPS as inflationary pressures continue to moderate. The inflation timing model has recently increased but is still at moderate disinflation levels. In other words, inflation continues to head lower but at a slower pace. Most indicators are bearish, with measures of commodity price trends heading lower, relative strength weakness, and lower inflation pressures negative for this credit sector.
Figure 4: Since 1962, when the Inflation Timing model signaled moderate disinflation, the CPI Index has declined at a 1.01% annualized rate.
U.S. Mortgage-Backed Securities: The Composite model improved slightly, with trend indicators reversing higher and inflation expectations now positive. During periods of low interest rates and strong housing markets, MBBs have performed well, providing higher yields than Treasury bonds while benefiting from the housing sector’s robustness. In contrast, MBBs not guaranteed by GSEs can suffer due to increased defaults on underlying mortgages during economic downturns or the housing market collapses. Currently, the decline in U.S. 10-year yields is supportive, as inflation expectations continue to move away from the extremes registered last year. We are neutral.
Figure 5: Mortgage-backed spreads are ticking higher, though still below the long-term average. This indicates that the MBS markets are functioning normally despite the housing deceleration.
U.S. Floating Rate: The model is negative, and measures of trend, momentum, and option-adjusted credit spreads are negative. We are currently underweight, but if the model's indicators start to pick up on a reversal from oversold extremes, we will increase exposure accordingly.
Figure 6: Momentum for U.S. Floating Rate Securities is still rated negative but may be finding support. We are looking for technical confirmation before adding exposure.
U.S. IG Corporates: IG corporate bonds performed well with stable yields, benefiting from improved credit fundamentals and increased investor demand. Favorable operating margins and positive earnings reports contributed to the solid performance. The Federal Reserve's pause in rate hikes and potential future rate cuts boosted investor confidence. This environment was particularly beneficial for bonds as investors sought higher yields in a stable interest rate scenario. The model held steady entering August, and the net result is a continued overweight position. Credit spreads are historically narrow, and credit default swaps costs are declining. Technical measures, including trend and mean reversion indicators, are supportive.
Figure 7: Lower credit default swap costs, indicating growing investor confidence.
U.S. High Yield: At the beginning of July, the economic environment was considered stable, reducing the perceived risk for high-yield bonds. This led to increased investment in higher-yielding securities, with tight spreads indicating lower risk premiums. Although the spreads were lower, the income generated from high-yield bonds acted as a buffer against potential price declines, making them an attractive option. Nonetheless, this all shifted toward the end of the month when investors started to question the strength of the U.S. economy and recession odds started to increase. This negatively impacted high-yield bond relative performance. The Composite model is supported by better trend and breadth statistics. However, small-cap equity trends and increasing option-adjusted spread levels are rolling over. We are neutral.
Figure 8: Small-cap equity performance often leads high yield fixed income performance.
International IG Corporate Bonds: The model remained weak entering August, with several technical and external factors at negative levels. Measures of trend, relative strength, and inflation expectations are headwinds at this time. Regional exposure for the index shows 57.6% of the holdings are from Europe and 19.7% from the Pacific region (credit quality shows 78.9% rated A or better). With the ECB cutting rates and expected to cut more over the course of the year, we will monitor the technicals for signs that the trend is reversing back to positive. We are neutral at this juncture.
Figure 9: Inflation extremes have moderated.
Emerging Market Bonds: The strength of the US dollar significantly influences EM bonds. A weaker dollar benefits EM bonds by lowering debt servicing costs for countries with dollar-denominated debt. Current expectations of a weaker dollar are providing a supportive backdrop for EM bonds. EM countries are projected to stabilize and potentially outpace developed markets in terms of economic growth, enhancing the attractiveness of EM bonds. Geopolitical stability is critical, and despite conflicts in regions such as the Middle East, the impact on EM bonds has been relatively contained. The outlook for emerging market bonds is influenced by expected rate cuts, easing inflation, a potentially weaker US dollar, positive relative economic growth prospects, and contained geopolitical risks. The EM bond model remained neutral entering August, with trend and momentum stabilizing. Weaker commodity pricing is a headwind.
Figure 10: Weaker commodity pricing is good for the inflation outlook but negative for EM fixed income as Emerging Markets equity indexes are positively correlated with commodity prices.
This strategy utilizes measures of price, valuation, economic trends, monetary liquidity, and market sentiment to make objective, unemotional, rational decisions about how much capital to place at risk and where to place that capital.
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Disclosures
The data and analysis contained within are provided "as is" and without warranty of any kind, either express or implied. The information is based on data believed to be reliable, but it is not guaranteed. Day Hagan DISCLAIMS ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY, SUITABILITY, OR FITNESS FOR A PARTICULAR PURPOSE OR USE. All performance measures do not reflect tax consequences, execution, commissions, and other trading costs, and as such, investors should consult their tax advisors before making investment decisions, as well as realize that the past performance and results of the model are not a guarantee of future results. The Smart Sector® Strategy is not intended to be the primary basis for investment decisions and the usage of the model does not address the suitability of any particular in Fixed Income vestment for any particular investor.
Using any graph, chart, formula, model, or other device to assist in deciding which securities to trade or when to trade them presents many difficulties and their effectiveness has significant limitations, including that prior patterns may not repeat themselves continuously or on any particular occasion. In addition, market participants using such devices can impact the market in a way that changes the effectiveness of such devices. Day Hagan believes no individual graph, chart, formula, model, or other device should be used as the sole basis for any investment decision and suggests that all market participants consider differing viewpoints and use a weight-of-the-evidence approach that fits their investment needs.
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