Day Hagan Smart Sector® Fixed Income Strategy Update December 2024
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Day Hagan Smart Sector® Fixed Income Strategy Update December 2024 (pdf)
Risk Management Update
The Catastrophic Stop model combines time-tested, objective indicators designed to identify high-risk periods for the equity and equity-related fixed-income markets. The model (Figure 1) held steady in November and entered December with a fully invested allocation recommendation. We will reduce duration and risk if our models shift to bearish levels (below 40% for two consecutive days).
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
Neutral
Overweight
Neutral
Neutral
Fixed Income Commentary
The current landscape of global fixed-income securities is reacting to a confluence of factors, including central bank policies, inflation trends, and geopolitical events. Central banks across the world are adjusting interest rates lower in response to slowing economic activity and decelerating inflation pressures. On November 7, the Federal Reserve reduced the benchmark rate by 25 basis points to 4.5% to 4.75%, the Riksbank (Sweden) cut rates by 50 basis points to 2.75%, and the Bank of England cut rates by 25 bps to 4.75%. History has shown that it is unwise to “Fight the Fed.”
In the U.S., the Federal Reserve is embarking on a non-recessionary rate-cutting cycle, which is anticipated to provide support for fixed-income assets globally. However, this backdrop is complicated by persistent inflationary pressures driven by structural fiscal deficits in many advanced economies. These deficits, exacerbated by demographic shifts and security concerns, are contributing to elevated real rates and inflation premiums. Additionally, soaring global debt levels, highlighted by the U.S. national debt surpassing $36 trillion in 2024, have raised serious questions about financial stability.
Concerns linger over the sustainability of current market rallies and the potential vulnerabilities that may arise in the coming years. The yield curve, for example, plays a pivotal role as an economic indicator; inverted yield curves, where short-term rates exceed long-term rates, typically signal expectations of an economic downturn. For fixed-income investors, careful monitoring of these dynamics is essential.
New risks have emerged as the lending landscape shifts from traditional banks to private credit markets. Investors are urged to exercise caution and ensure their portfolios are diversified while employing robust risk management strategies to navigate the challenges posed by lower-quality credit. Geopolitical tensions and conflicts further complicate the environment, contributing to market volatility and impacting investor confidence in fixed-income markets.
While there are positive aspects to the outlook for U.S. fixed-income investments, a cautious approach is warranted. Economic growth, although slowing, remains firm, with low unemployment levels suggesting a potential soft landing. However, tighter valuations, marked by historically narrow corporate credit spreads, may counterbalance positive fundamentals. In this context, a balanced and centrist portfolio risk positioning is advisable to navigate the uncertainties stemming from ongoing budgetary issues, the potential introduction of new trade tariffs, and persistent geopolitical conflicts, including those in the Middle East and the war involving Russia and Ukraine.
Sector Commentary
U.S. Treasuries: The Treasury yield curve has experienced significant shifts throughout the year, particularly in the last few months. This shift is not confined to Treasuries; the corporate yield curve is also evolving. Once relatively flat across various maturities, the corporate curve now reflects a more upward-sloping shape through the 10-year mark before flattening out. A steeper curve indicates an increasing balance of reward (income) against risk (duration and price) for long-term investments. Two key characteristics of this changing rate landscape are crucial for considering fixed-income allocations in investment portfolios: first, the upward slope of the curve that rewards additional risk with higher income, and second, the fact that interest rates are currently higher than they have been in 15 years. The Federal Reserve initiated this phase of easing with a significant 50 basis point (bp) rate cut and seems determined to maintain a trajectory of reducing interest rates at a quarter-percent pace to achieve neutral rates. As of this writing, the committee has already implemented 75 bps in cuts, adjusting policy rates from a range of 5.25%-5.50% down to 4.50%-4.75%. However, the Fed’s data-dependent approach leaves the outlook for further easing uncertain. History shows that such Fed rate cuts often lead to increased rate volatility. Furthermore, the long end of the yield curve will likely be shaped by forthcoming fiscal policy discussions and potential inflationary pressures. With these dynamics in play, we anticipate that long-term interest rates, specifically the nominal U.S. 10-year Treasury yield, should trend modestly lower from current levels. We are currently neutral.
Figure 2: Bonds have typically done well during periods of strong economic growth and low inflation.
U.S. TIPS: The Federal Reserve’s rate cuts aimed to bolster economic growth amid softening inflation, which generally leads to reduced yields on fixed-income securities like TIPS, consequently raising their prices. According to data released on November 27, the Personal Consumption Expenditures (PCE) index, the Fed’s preferred inflation measure, rose by 0.2% in October, with a year-over-year increase of 2.3%. The core PCE, excluding food and energy, also advanced by 0.3%, reaching 2.8% year-over-year, highlighting persistent inflation above the Fed’s 2% target. Meanwhile, the Conference Board’s Consumer Confidence Index surged to 111.7 in November, its highest in 16 months, reflecting optimism about the labor market and potential consumer spending increases that could further pressure inflation. Lastly, the U.S. economy recorded a robust annualized growth rate of 2.8% in the third quarter of 2024, suggesting a strong economic landscape that could influence inflation expectations and boost TIPS valuations. Currently, the TIPS composite model’s technical indicators remain negative. Should there be improvement, we would look to add exposure. We remain underweight.
Figure 3: Commodities have been trending lower. Bullish for bonds, bearish for TIPS.
U.S. Mortgage-Backed Securities: Following the first cut by the Federal Reserve, the average rate for a 30-year fixed mortgage decreased slightly to 6.81%, down from 6.84% the previous week, but rates have since moved back near the recent highs. The party didn’t last long. Concurrently, the Fed continues its quantitative tightening strategy by reducing its MBS holdings, which fell to approximately $2.262 trillion as of November 20. This decline in demand from a significant buyer could increase MBS yields, potentially balancing out any benefits from lower interest rates. High mortgage rates and rising home prices have also limited home sales, which have hit their lowest levels since 1995. Economists anticipate continued volatility in mortgage rates, projecting they may hover around 6% in 2025, influenced by the Fed’s policies and inflation trends. The composite model improved slightly as inflation expectations softened. However, the model’s indicators remain mixed with measures of trend, credit spreads, and overbought/oversold negative. We remain neutral.
Figure 4: High-yield option-adjusted spreads are narrow, creating competition for higher-quality sectors.
U.S. Floating Rate Notes: Market participants adjusted their investment strategies to anticipate further interest rate cuts. As expectations of ongoing declines in rates intensified, floating rate securities, which generally thrive in rising rate environments, became less appealing. This shift in sentiment was evident in the performance of related investment funds. For example, the iShares Floating Rate Bond ETF (FLOT) recorded a year-to-date return of 5.94% as of November 27, 2024, reflecting modest gains even as the interest rate landscape evolved. Yields are currently overbought, and a reversion to the mean is expected. We are underweight.
Figure 5: Market volatility has subsided, which has been a headwind for Floating Rate Notes.
U.S. IG Corporates: Like last month, positive earnings reports from major corporations bolstered investor confidence in the creditworthiness of investment-grade issuers. Companies across various sectors reported earnings that exceeded expectations, contributing to tighter credit spreads and increased demand for corporate bonds. The composite model is mixed, with indicators calling the U.S. dollar, credit default swaps, and mean reversion positive. We are neutral.
Figure 6: Credit Default Swap values have reversed and are decreasing, indicating that investors are becoming more positive about the investment-grade corporate sector.
U.S. High Yield: The High-yield bond composite model has improved, reversing the decline seen heading into November. Measures of breadth, trend, and volatility shifted to buy signals. Corporate earnings in the U.S. came in strong, with Q4 earnings expected to be up over 10% year-over-year. U.S. economic growth is slightly above trend, small-cap stock performance has been strong, and investors are more positive on the sector’s creditworthiness (based on narrowing credit spreads). We are adding exposure and are now overweight.
Figure 7: Small-cap equity performance often leads to high-yield fixed-income outperformance.
International IG Corporate Bonds: Global economic growth has been slowing, especially in former leaders like China and India. This isn’t to sidestep the weakness in the Eurozone, with the U.K., France, and Germany especially weak. The dour economic outlook for these regions is creating a bid for bonds as a safe haven, even though fiscal and monetary stimulus measures continue to strain budgets and pile on sovereign debt. As written last month, “According to the OECD, global economic growth projections continue to run around 3.2% for 2024 and 2025. They believe the growth will be supported by easing inflation, improving real incomes, and accommodative monetary policies.” While this may eventually be the case, our indicators are mixed and support a neutral allocation at this time.
Figure 8: The composite model’s relative strength indicator remains on a buy signal for International Treasuries.
Emerging Market Bonds: The EM bond composite model held steady entering December, but there were some indicator shifts. A trend indicator turned bullish, while a price trend indicator for Emerging Market equities turned bearish. The model remains mixed, with measures of commodity strength, trend, and relative strength positive. Weakness in EM currencies and emerging market equities is bearish. We remain neutral on the sector.
Figure 9: The EM currency basket continues to lose ground against the U.S. dollar. A reversal would be bullish.
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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Smart Sector® Fixed Income ETF
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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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