Day Hagan Smart Sector® Fixed Income Strategy Update February 2025
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Day Hagan Smart Sector® Fixed Income Strategy Update February 2025 (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) improved in January and entered February with a fully invested allocation recommendation. If our models shift to bearish levels (below 40% for two consecutive days), we will reduce exposure to fixed-income sectors with high correlations to equities.
Figure 1: The Catastrophic Stop Model level is 72.86%.
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
Underweight
Neutral
Underweight
Neutral
Neutral
Overweight
Neutral
Neutral
Fixed Income Commentary
The Federal Reserve cut interest rates by 25 basis points in December 2024, bringing the target range to 4.25% to 4.50%. However, in January, the Fed indicated a cautious stance, suggesting a pause on further rate cuts due to persistent inflation worries and strong economic performance. Similarly, the European Central Bank lowered its benchmark interest rate by 25 basis points to 2.75% amid signs of slowing growth and inflation within the eurozone, leading to divergent yield movements globally.
U.S. fiscal policy also influenced market dynamics, as newly implemented tariffs on imports from Mexico, Canada, and China raised inflation expectations. Traders forecasted a consumer price index inflation rate approaching 3% for much of the year, resulting in a one-year breakeven rate of 2.84%. These expectations stirred discussions on potential Fed rate hikes. Additionally, fluctuations in global commodity prices, particularly energy, further shaped inflation rates across different countries, impacting their bond markets. Major U.S. companies accelerated their bond issuances in response to rising borrowing costs driven by increased Treasury yields. This influx of supply created volatility, affecting the stock market as companies sought to lock in yields amid inflation concerns.
Geopolitical tensions, particularly resulting from U.S. tariffs, disrupted global trade dynamics, leading to increased investor sentiment volatility. The political climate surrounding the incoming Trump administration introduced uncertainty about fiscal policies, exacerbating market fluctuations. Investor behavior reflected these uncertainties, as some opted for cash, drawn by its appealing returns despite expectations of supportive bond rates. Robust economic indicators, including labor market strength and consumer spending, prompted nuanced risk premium adjustments and duration positioning within the fixed-income space. Collectively, these elements defined the landscape of fixed-income markets in January 2025, shaping yield movements and investor strategies across the globe.
Sector Commentary
U.S. Treasuries: U.S. Treasury yields declined during the last week of January, while credit spreads generally widened amid concerns regarding the U.S. growth outlook and trade tariffs. The Federal Reserve maintained its interest rates, with Chair Powell adopting a modestly hawkish tone, while the European Central Bank reduced its policy rate by 25 basis points as anticipated. During the month’s final week, the 10-year Treasury yields fell by eight basis points to 4.54%, and the 2-year yields decreased by seven basis points to 4.20%. The week was eventful, with central bank meetings and headlines early in the week regarding a new AI program from China’s DeepSeek that contributed to a downturn in risk assets and Treasury yields. At the end of the month, trade policy announcements prompted a rise in yields and widening spreads due to potential inflationary tariffs. The Composite model was unchanged, with technical measures showing weakness and inflation expectations increasing. The net result is we are more focused on the short end of the Treasury curve.
Figure 2: Rising inflation expectations are a headwind. However, bonds are poised for a reversal should expectations reverse lower.
U.S. TIPS: The front end of the inflation curve remains highly responsive to trade policy developments, performing well following President Trump’s reaffirmation of plans to impose 25% tariffs on Canada and Mexico, in addition to a 10% tariff on China, effective February 1. Despite the announcement, uncertainty persists regarding these tariffs’ implementation timeline, potential exemptions, and duration. As inflation swaps approach the upper boundary of their six-month range, we acknowledge varying near-term risks. In the upcoming quarterly refunding meeting, we expect the Treasury to announce gradual increases in auction sizes for 5- and 10-year TIPS while maintaining nominal auction sizes. The bond market has exhibited relative stability throughout this period, partly due to the Federal Reserve’s cautious approach and maintained interest rates. Technical measures, rising commodity price trends, relative strength indicators, and rising inflation expectations are supportive. The Composite model improved with the February update, and we are increasing exposure.
Figure 3: Commodities have been trending lower. Bullish for bonds, bearish for TIPS.
U.S. Mortgage-Backed Securities: Toward the end of January, mortgages outperformed, albeit modestly, driven by a decline in volatility. The movement in option-adjusted spreads (OAS) remained subdued, reflecting a tight trading range influenced by seasonality and limited refinancing activity, resulting in low supply. Despite less compelling mortgage OASs, spreads in other sectors remain tight, and there has been a notable firming. The demand from banks and money managers appears robust, as recent data indicates a rebound in fixed income inflows following a brief outflow period. Additionally, homebuilder loan issuance remains strong, averaging $3 billion monthly. Looking ahead, investor sentiment seems stable, supported by consistent demand. We remain neutral.
Figure 4: High-yield option-adjusted spreads remain narrow, indicating investors do not foresee a major dislocation.
U.S. Floating Rate Notes: The U.S. economy demonstrated stronger-than-anticipated growth, and inflation rates continued to exceed the Federal Reserve’s target of 2%. Ongoing inflationary pressures significantly impacted market expectations around upcoming interest rate changes, influencing the demand and pricing of floating rate notes (FRNs). In a recent policy statement revision, Fed Chair Jerome Powell characterized the adjustments as mere “language cleanup,” clarifying that they were not intended to signal a shift in policy direction. Nonetheless, the revisions took a hawkish tone by indicating that inflation is still “somewhat elevated” rather than suggesting it has made “progress” toward the target. The statement also conveyed a more optimistic outlook on the labor market, highlighting that “the unemployment rate has stabilized at a low level.” We anticipate two rate cuts within the year, lowering the policy rate to between 3.75% and 4.00%, contingent on forthcoming inflation and labor market data, along with developments from the Trump administration. Following the Fed’s meeting, the European Central Bank also reduced its benchmark interest rate by 25 basis points to 2.75%, reflecting waning growth and inflation in the eurozone. We are neutral.
Figure 5: Momentum is starting to wane. We will reduce exposure if other technical indicators confirm a new downtrend.
U.S. IG Corporates: Investment-grade corporate bonds demonstrated positive performance with a return of 0.34%, although they trailed behind comparable-duration Treasuries by 9 basis points. In a sign of robust market confidence, inflows into this asset class accelerated, totaling $4.8 billion, while issuance exceeded expectations amid a backdrop of volatility and central bank meetings. Approximately $31 billion was priced during the last week of January, bringing the monthly total to over $191 billion. Demand remained strong, reflected in average oversubscription rates of three times and minimal new issue concessions of just 1.5 basis points. This surge in corporate bond sales—amounting to a remarkable $83 billion early in the month—was propelled by notable issuers such as BNP Paribas, Société Générale, Toyota, and Caterpillar. Companies sought to secure funding proactively in anticipation of potential market fluctuations linked to political developments, while tightening credit spreads indicated increased investor confidence in corporate solvency. Ultimately, in a low-yield environment, higher returns from corporate bonds attracted investors seeking safer alternatives amidst economic uncertainties. We remain neutral.
Figure 6: A confirmed downtrend in the U.S. dollar would be negative for U.S. IG Corporates.
U.S. High Yield: High-yield corporate bonds attract significant inflows—$196 million into high-yield funds and $1.5 billion into loan funds. This marks the fourth consecutive week of senior loan inflows exceeding $1 billion, contributing to nearly $15 billion over the past 12 weeks. Current market conditions support pricing, as over 50% of loans are trading above par, fostering an active refinancing environment with $32 billion in pricing for the week versus $7.4 billion in high yield. High-yield bond spreads widened by four basis points but remain close to post-global financial crisis lows, influenced by rising equity volatility and a subdued Federal Reserve meeting. Strong corporate earnings and low default rates are bolstering investor confidence alongside robust issuance as companies capitalize on favorable conditions to manage existing debt effectively. The Composite model improved this month, with supportive measures of trend, breadth, and OAS extremes. Interestingly, the weakness in small caps we highlighted last month continued and remains a headwind. We’re still overweight but will reduce if more indicators shift to negative readings.
Figure 7: Relative weakness in small-cap stocks is still a headwind.
International IG Corporate Bonds: In recent weeks, European high-grade (EUR HG) bonds have outperformed their U.S. counterparts, driven by several key factors. These include a relatively stable issuance environment, increased retail inflows, progress in French budget negotiations, and an absence of significant tariff discussions affecting Europe. The European Central Bank’s ongoing easing stance also contributed to this trend. In a low-yield environment, the search for higher returns has led investors to favor investment-grade corporate bonds, drawn by their comparatively attractive yields over government securities amidst ongoing economic uncertainties. Consequently, yields on investment-grade bonds have risen notably, enhancing their appeal from both an income and valuation standpoint. Historical data suggests that the most favorable returns on investment-grade bonds tend to occur during periods of moderate economic growth, typically within the 1-3% range. Forecasts indicate that in 2025, moderate growth rates of 2.0% in the U.S. and 1.1% in Europe may further support the performance of this asset class. The Composite’s indicators are mixed and support a neutral allocation.
Figure 8: Indicators using option-adjusted spreads to call International Treasuries are neutral.
Emerging Market Bonds: Emerging markets outperformed, surpassing similar-duration Treasuries by 11 basis points, while attracting inflows of $65 million during the last week of January. Much of this rally occurred before significant tariff news was released on Friday. The U.S. dollar, which typically poses a challenge for emerging markets amid strengthening trends, gained approximately 1% overall and over 2% against the Mexican peso, influenced by tariff developments. The prospect of U.S. trade policies, especially following President Donald Trump’s re-election, spurred concerns over potential tariffs, leading to a record $26 billion in bond sales by developing nations in early January as they positioned themselves for anticipated volatility. To counter risks from U.S. trade actions, investors increasingly shifted focus to frontier markets—such as Serbia, Ghana, Zambia, and Sri Lanka—drawing interest due to their growth potential and recent debt restructuring. Additionally, diverging monetary policies across major economies impacted emerging market bonds, with India’s yields falling on expected rate cuts. At the same time, China faced deflationary concerns that similarly affected its bond market yields. We remain neutral.
Figure 9: Relative strength in emerging market equities would be bullish for EM bonds. A rise above 0% would flip this indicator positive.
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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