Day Hagan Smart Sector® Fixed Income Strategy Update January 2025
A downloadable PDF copy of the Article:
Day Hagan Smart Sector® Fixed Income Strategy Update January 2025 (pdf)
Risk Management Update
The CaThe 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 December and entered January 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: 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
From a market technical perspective, the Federal Reserve’s recent decision to lower the federal funds rate target range by 25 basis points to 4.25%-4.50% was interpreted as a “hawkish cut,” establishing a potential rate floor of 3.5%-4% through 2025. The yield curve is flattening as markets adjust to the slower anticipated pace of rate normalization, while tightened credit spreads suggest a growing comfort with the economic outlook.
Despite existing stretched valuations in fixed-income sectors, the combination of relative economic strength, easing inflation, and ongoing less-aggressive Fed cuts is likely to benefit credit sectors in early 2025. Investors may find opportunities amid brief market dislocations, particularly as the new administration seeks balance in its policy initiatives. Moreover, third-quarter earnings for the S&P 500 surpassed expectations, with a notable 8.7% increase in earnings driven largely by the technology sector. Healthy consumer spending and a gradual slowdown in the employment market position the economy favorably for 2025. Increased confidence from small businesses, reflected in the NFIB optimism index, combined with a flattened yield curve and tightened credit spreads, bodes well for the future, even as uncertainties remain regarding fiscal policies. Overall, the fundamentals appear supportive of sustained growth ahead.
The November employment report in the U.S. revealed the addition of 227,000 jobs, signaling a strong labor market, with wage growth reaching 4.0% year-over-year, consistent with the Federal Reserve’s inflation targets. Retail sales for the same month surpassed expectations, increasing by 0.7%, primarily driven by high demand for durable goods, which reflects robust consumer spending. In terms of geopolitical events, Germany experienced political turmoil as Chancellor Olaf Scholz lost a confidence vote. At the same time, Canada grappled with the resignation of Finance Minister Chrystia Freeland over policy disputes. These developments have contributed to heightened volatility in global markets, impacting investor sentiment, particularly in fixed-income arenas. Meanwhile, the recent U.S. election outcomes have sparked optimism for deregulation and increased economic growth in 2025, fostering a more favorable risk appetite in residential mortgage credit.
Sector Commentary
U.S. Treasuries: The yield curve flattened as markets absorbed positive economic reports, suggesting the Federal Open Market Committee (FOMC) may follow a slower trajectory toward rate normalization. Although credit spreads have tightened, they indicate no immediate signs of stress, reflecting confidence in the economic outlook. The Federal Reserve implemented a 25-basis point interest rate cut during its December meeting, marking the third reduction of the year, which totals a 1.0% decrease. Fed Chairman Powell noted an improved economic landscape compared to September when the first cuts began. As a result, investors have adjusted their expectations, anticipating only two more rate cuts of 25 basis points each in the year ahead. Although the Fed considers the current policy environment to be restrictive—though less so than in the past—it acknowledges the need to slow the pace of cuts as it nears the estimated neutral rate. Looking forward, we expect gradual rate cuts in 2024 but advise flexibility as ongoing changes in the administration’s policy priorities and economic data unfold. Markets are forecasting the 10-year U.S. Treasury yield within a range of 3.75% to 4.75%, influenced by potential fiscal policy changes and ongoing labor market developments. 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 but will add duration as the technical indicators improve.
Figure 2: Rising inflation expectations are a headwind. However, bonds are poised for a reversal should expectations reverse lower.
U.S. TIPS: As of November 2024, the annual U.S. inflation rates have shown some improvement, with all-items inflation at 2.7% and core inflation at 3.3%, a decline from 3.1% and 4.0% in November 2023, respectively. Despite this progress, both measures have been experiencing an uptick in recent months, raising concerns for the Federal Reserve. In its latest meeting, the Fed revised its 2025 inflation forecasts for the Personal Consumption Expenditures Price Index (PCE) to 2.5% for all items and core, up from previous estimates of 2.1% and 2.2%. Concurrently, interest rates were reduced. The PCE generally reflects lower inflation trends compared to the headline Consumer Price Index (CPI), suggesting that actual U.S. inflation could surpass 2.5% in 2025, potentially stabilizing around 2.7% to 3.0% for several months. If 10-year inflation expectations are anchored at 2.4%, the real yield on a 10-year Treasury Inflation-Protected Security (TIPS) might rise to 2.6% or higher from the current 2.23%. Given these circumstances and the model’s bearish reading, we remain underweight.
Figure 3: Commodities have been trending lower. Bullish for bonds, bearish for TIPS.
U.S. Mortgage-Backed Securities: In December, the Federal Reserve hinted at a potential slowdown in its balance sheet reduction, particularly regarding mortgage-backed securities (MBS). Analysts speculated that the Fed might reduce the pace of tapering to maintain market stability, possibly extending the quantitative tightening (QT) into mid-2025. Consequently, this outlook helped stabilize markets as investors adjusted to the idea of continued Fed support. Bond markets experienced significant volatility, with 10-year Treasury yields affecting MBS pricing, as shifts in Treasury yields influence mortgage rates and investor interest. Encouraging employment reports and strong consumer spending indicated a resilient economy, which in turn shaped investor sentiment about MBS, often leading to expectations of higher interest rates. The holiday season further complicated the market, as low trading volumes fueled volatility, resulting in MBS performance that sometimes diverged from fundamental economic indicators. Amidst this backdrop, investors showed heightened interest in higher-yielding assets like MBS, driven by the pursuit of better returns in a low-interest-rate environment, ultimately boosting demand for these securities. 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 remain narrow, indicating investors do not foresee a major dislocation.
U.S. Floating Rate Notes: In December, the Federal Reserve announced a 25-basis point rate cut, aligning with market expectations and resulting in lower reference rates for floating rate notes (FRNs). As coupon payments declined, the attractiveness of FRNs diminished for investors seeking better yields. Throughout 2024, inflation rates began to stabilize, lessening the urgency for aggressive monetary tightening and prompting the Fed to reduce interest rates further. This environment led to a noticeable shift in investment preferences; investors began moving from floating-rate instruments to fixed-rate securities, which provided more predictable returns amid declining rates. Consequently, funds focused on floating rate assets experienced significant outflows, contributing to downward pressure on FRN prices. Additionally, the economic outlook affected investor demand for FRNs based on the issuing entities’ credit quality. As concerns grew over potential economic slowdowns, investors gravitated toward higher-quality issuers, influencing the pricing and demand dynamics within the FRN market. This confluence of factors has reshaped the landscape for FRNs and the broader fixed-income environment. Yields are currently overbought, and a reversion to the mean is expected. We are underweight.
Figure 5: Rates backed up in December; we now expect a reversion from overbought levels. However, we require technical confirmation. If the FLRN 5-day relative MA declines below the 63-day MA, it would be a good indication that rates are likely to head lower.
U.S. IG Corporates: Like the last two months, 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 remain neutral.
Figure 6: Lower bond volatility supports corporate fixed-income prices (lower yields).
U.S. High Yield: High-yield bonds held up relatively well in December, significantly outperforming longer-term Treasuries. Last month, we added exposure to overweight due to model improvement (measures of trend, breadth, small-cap equity correlations, volatility, and credit spreads were positive). Many of those indicators are now pointing to overbought conditions and some breadth deterioration. In response, we modestly reduced exposure and remained slightly overweight.
Figure 7: Last month, we noted that small-cap equity performance often leads to high-yield fixed-income outperformance. With the December pullback in small caps, this indicator has now shifted to a negative reading.
International IG Corporate Bonds: The U.S. economy exhibited impressive growth, with the S&P 500 soaring 24% due to advancements in artificial intelligence and strong economic signals, enticing global investments toward American assets. In contrast, Europe struggled, marked by instability like the fall of France’s minority government, leading to volatility in its bond markets. Meanwhile, major central banks such as the European Central Bank and the Bank of Japan upheld accommodative policies, subtly influencing global bond yields. In 2024, the U.S. dollar rose 6.6%, diminishing the appeal of foreign bonds. Despite these challenges, global bond funds saw record inflows surpassing $600 billion, reflecting robust investor interest. The Composite’s indicators are mixed and support a neutral allocation.
Figure 8: Increasing equity volatility has historically been positive for investment-grade international bonds.
Emerging Market Bonds: EM bonds in local currency performed relatively well in December, but the continued strength in the dollar nullified a portion of the gains. EM bonds (in USD) significantly outperformed U.S. Treasuries, municipal bonds, MBS, and TIPS for the year. Currently, the U.S. dollar is overbought, and investor sentiment is overly optimistic. We are monitoring our models for signs that the dollar has registered a decisive peak and is likely to enter a downtrend. Should that come to pass, we will look to add exposure to this sector. Currently, the composite model is mixed. If measures of EM equity momentum and EM currency turn positive, the model will shift to an overweight recommendation. 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.
For more information, please contact us at:
Day Hagan Asset Management
1000 S. Tamiami Trl
Sarasota, FL 34236
Toll Free: (800) 594-7930
Office Phone: (941) 330-1702
Website: https://dayhagan.com or https://dhfunds.com
© 2025 Day Hagan Asset Management
Charts courtesy Ned Davis Research (NDR). © Copyright 2025 NDR, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo.
Day Hagan/Ned Davis Research
Smart Sector® Fixed Income ETF
Symbol: SSFI
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.
Past performance does not guarantee future results. No current or prospective client should assume future performance of any specific investment or strategy will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals and economic conditions may materially alter the performance of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio. Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. There can be no assurances that a portfolio will match or outperform any particular benchmark.
Day Hagan Asset Management is registered as an investment adviser with the United States Securities and Exchange Commission. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the adviser has attained a particular level of skill or ability.
There may be a potential tax implication with a rebalancing strategy. Re-balancing involves selling some positions and buying others, and this activity results in realized gains and losses for the positions that are sold. The performance calculations do not reflect the impact that paying taxes would have, and for taxable accounts, any taxable gains would reduce the performance on an after-tax basis. This reduction could be material to the overall performance of an actual trading account. Day Hagan does not provide legal, tax or accounting advice. Please consult your tax advisor in connection with this material, before implementing such a strategy, and prior to any withdrawals that you make from your portfolio.
There is no guarantee that any investment strategy will achieve its objectives, generate dividends or avoid losses.
© 2024 Day Hagan Asset Management
