Day Hagan Smart Sector® Fixed Income Strategy Update June 2024
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Day Hagan Smart Sector® Fixed Income Strategy Update June 2024 (pdf)
Risk Management Update
The risk management model (Figure 1) seeks to reduce exposure to fixed-income sectors most sensitive to equity drawdowns. The model improved during the month and entered June, recommending full exposure.
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)
Underweight
Overweight
Overweight
Underweight
Underweight
Underweight
Neutral
Overweight
Neutral
Neutral
Fixed Income Commentary
Central Bank policy is becoming less of a headwind. Out of 31 global central banks that we track, 28 are expected to reduce policy rates at the next scheduled meeting, with three on hold. Central Banks for Canada, Mexico, the Euro area (ECB), the U.K., Chile, Columbia, Peru, Hungary, and the Czech Republic are expected to lower rates in June. The expectations for a U.S. rate cut are slowly being pushed out from June, with July now being the current expectation. While there have been discussions around the possibility of a Fed rate hike, the data assigns this a very low probability. Overall, the percentage of central banks whose last rate change was a decrease is edging higher and, given current expectations, will likely soon cross above 50% (Figure 2). This is a positive tailwind for fixed income.
Figure 2: Breadth of Central Bank Rate Changes
Fixed income tends to perform well during periods of economic weakness, stock market volatility, moderate disinflation, and around crisis events (financial and non-financial). While global economic growth is positive overall, there have been signs that it is decelerating. We see global economic growth expectations moving lower with unemployment creeping higher, increasing consumer credit delinquencies, slowing home sales, an inverted yield curve, and exceptional corporate earnings growth limited to only a handful of companies. We also note that inflation pressures are currently neutral, and geopolitical risks are elevated. That leaves market volatility, which is muted—until it’s not.
Longer-term, fixed-income trends will continue to hinge on whether rates react more to 1) reduced inflation expectations and slower economic growth (positive for bonds as interest rates decline) or 2) ever-increasing levels of supply due to the breathtaking levels of sovereign debt loads and budget deficits for as far as the eye can see (negative for bonds as rates increase). Recent data releases and Fed commentary suggest the Fed is unhappy with the trajectory of inflation and is concerned that disinflation has stalled. This is likely to prohibit rates from moving significantly lower, though a couple of rate cuts are still expected. This view is confirmed by several indicators calling bond duration.
Sector Commentary
Treasuries: Technical momentum and reduced inflation expectations continue to favor U.S. Treasuries, primarily at the longer end of the curve. Slowing economic growth may allow the Fed to lower rates as soon as July. Regarding supply, recent U.S. Treasury bond auctions have shown varying results, reflecting the current economic conditions and market sentiments. For instance, a recent auction for 7-year notes resulted in a high yield of 4.65%, with significant demand reflected in a bid-to-cover ratio of 2.43, indicating strong investor interest. Another notable auction for 30-year bonds also saw solid demand with a high yield of 4.64% and a bid-to-cover ratio of 2.49, showing sustained investor appetite for long-term government debt.
Figure 3: U.S. Long-Term Treasury Inflation Expectations.
TIPS: We are currently underweight TIPS as inflationary pressures moderate. While a few commodity price trends outside of energy have increased (copper) over the past few months, indicators calling housing trends, energy prices, and input prices (PPI) have moderated. Overall, the Inflation Timing Model remains in the “Moderate Disinflation” zone.
Figure 4: Since 1962, when the Inflation Timing model signaled moderate disinflation, the CPI Index has declined at a 1.0% annualized rate.
U.S. Mortgage-Backed Securities: The Composite model is mixed, with trend indicators rolling over and inflation expectations now neutral. 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.
Figure 5: Mortgage-backed spreads have decreased after a mid-May spike, though still below the long-term average.
U.S. Floating Rate: Economic surprises this year have generally been to the downside. Inflation pressures, as mentioned earlier, are neutral. The sector model shows that technical momentum has turned negative, and option-adjusted spreads are ticking higher. The two trend indicators that remain supportive are tracking toward negative readings. The net result is that we are currently underweight.
Figure 6: One of the last supporting indicators based on trend is closing in on a sell signal.s
U.S. IG Corporates: Positive contributors to the model include trends in option-adjusted spreads (narrowing), credit default swaps (declining), and a reversal from oversold conditions. Negative contributors are a potentially weaker U.S. dollar and an intermediate-term MACD indicator still on the March sell signal (correctly calling the weakness in corporates over the past few months). The weight of the evidence is neutral.
Figure 7: Simple trend-following indicators help keep the model on the right side of major trends. This indicator is poised to generate a buy signal.
U.S. High Yield: As equities go, so goes high yield (most of the time). A continuation of the resurgence in small-cap stocks and better equity market breadth would be supportive. The investment model rates trend and breadth as bullish, with lower equity volatility, credit spreads behaving, and small-cap equities holding up as additional bullish supports.
Figure 8: Small-cap equity uptrends support high-yield bonds.
International IG Corporate Bonds: The model deteriorated in May, and several technical and external factors are now negative. Measures of trend, relative strength, and inflation expectations are headwinds at this time. Much of the concern around International corporate bonds is the below-trend economic growth within the EU (0.4% annualized through Q1) and Japan (-0.2%). Regional exposure for the index shows 57.4% of the holdings are from Europe and 20.1% from the Pacific region (credit quality shows 78.3% rated A or better). With the ECB expected to cut rates soon, we will monitor the technicals for signs that the trend is reversing back to positive. We are neutral at this juncture.
Figure 9: Looking for technical improvement before adding exposure.
Emerging Market Bonds: The EM bond model looks better than the International IG Corporates model. Measures of momentum and trend are more positive and EM economic growth has been stronger. We remain overweight.
Figure 10: Emerging Market equities have been doing well, supporting EM bond 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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