Day Hagan Smart Sector® Fixed Income Strategy Update May 2025
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Day Hagan Smart Sector® Fixed Income Strategy Update May 2025 (pdf)
Executive Summary
In April, the U.S. and global fixed income markets experienced a complex interplay that shaped investor sentiment and asset performance. On the positive side, a noticeable easing in tariff-related tensions and the improvement of trade rhetoric marked a significant shift in the U.S. trade landscape. The Trump administration signaled a potential pause on certain tariffs, while China expressed a willingness to engage in negotiations. This renewed investor confidence led to a rebound in investment-grade corporate bonds.
Additionally, the Federal Reserve’s dovish outlook played a crucial role in shaping market dynamics. Fed officials, including Governor Waller and Cleveland Fed President Hammack, made it clear that they would consider cutting interest rates in response to weakening labor market conditions. By the end of April, markets had priced in a 70% chance of a rate cut by June, with expectations of a total of 3.5 rate cuts throughout 2025. Consequently, the 10-year Treasury yield fell to 4.01% on April 4, closing at 4.17% for the month.
High-quality fixed income sectors also performed well amidst the prevailing uncertainty. U.S. agency mortgage-backed securities (MBS) and investment-grade corporate bonds delivered attractive yields, with agency MBS spreads tightening during the month. Notably, investment-grade corporates outperformed Treasuries. The heightened demand for safer fixed-income assets underscored a preference for quality amid market fluctuations.
Global monetary easing further supported bond markets, as most G10 central banks, excluding Japan, signaled intent to continue rate cuts. The European Central Bank’s easing cycle, in particular, bolstered demand for corporate credits in Germany. Meanwhile, emerging market sovereign debt remained an appealing option for yield-seeking investors, contributing to greater stability in the global bond market.
Conversely, the fixed income landscape also faced significant challenges. Notably, the announcement of near-universal U.S. tariffs on April 2 incited uncertainty, resulting in volatile Treasury yields and wider credit spreads. By mid-April, investment-grade corporate spreads were wider than pre-tariff levels, adversely impacting returns.
Persistently high inflation also posed a threat, with U.S. core PCE inflation rising to 2.5% by February 2025 and core CPI at 2.8% through March. These inflation pressures constrained the Federal Reserve’s capacity to implement aggressive rate cuts, keeping bond yields elevated, especially for long-duration assets.
The outlook for emerging markets weakened significantly, as the International Monetary Fund revised its growth forecasts downward due to tariff-related disruptions and slowing global demand. This downgrade heightened credit risks for emerging market bonds, exacerbated by depreciating local currencies and elevated debt levels.
Additionally, vulnerabilities in the commercial mortgage-backed securities (CMBS) sector emerged, driven by potential refinancing risks amid stagnant interest rates. Investors grew cautious of this segment, reflecting a downturn in the U.S. office real estate market.
Lastly, heightened term premiums in the Treasury market arose due to concerns over persistent fiscal deficits and the sustainability of U.S. debt under the current administration’s policies. The 10-year Treasury yields remained trapped within a 4%-5% range, limiting bond price appreciation.
In summary, the fixed income markets in April were characterized by a dual narrative of cautious optimism and pronounced risk factors. While high-quality assets benefited from a flight to safety, pressures from inflation and emerging market vulnerabilities continued to challenge investors. Navigating this landscape in April required a focus on high-quality credits and shorter-duration bonds to mitigate associated risks. Notably, we had increased short-duration bonds entering last month.
Holdings
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)
Overweight
Overweight
Neutral
Neutral
Neutral
Underweight
Neutral
Neutral
Neutral
Underweight
Position Details
U.S. Treasuries: Entering May, the composite model declined as technical measures deteriorated, the weaker U.S. dollar impacted investor appetite, and mean reversion indicators have yet to reverse. We remain focused on the shorter end of the curve (which would likely perform best once rate cuts are implemented).
Commentary: U.S. Treasuries experienced notable volatility. A temporary pause in tariffs, aimed at alleviating trade tensions, led to a reduction in 10-year Treasury yields, which fell to 4.01% on April 4. The Federal Reserve’s dovish stance, with a 70% probability of a rate cut in June, enhanced the appeal of Treasuries as safe-haven investments. A successful $39 billion Treasury auction provided stability, and strong demand for 2-year Treasuries indicated investor confidence. However, the month was not without challenges; initial tariff announcements caused a sell-off, pushing yields as high as 4.48%. Persistent inflation, evidenced by a core PCE at 2.8%, constrained expectations for significant rate cuts, while fiscal deficit concerns kept yields elevated. Overall, despite these obstacles, Treasuries continued to play a pivotal role in fixed income strategies, balancing both risk and opportunity.
Figure 1: CDS rates have recently reversed.
U.S. TIPS: The TIPS composite model deteriorated into the May update due to weakening technicals, decelerating commodity price trends, increasing inflation expectations, and widening credit spreads (though they modestly retreated by the end of the month). There has been a mild short-term trend improvement that we are monitoring, but it is not enough to turn more positive on the sector.
Commentary: U.S. Treasury Inflation-Protected Securities (TIPS) showed mixed performance amid shifting economic factors. Positive indicators included a rise in 10-year real yields to 2.28% and 30-year yields to 2.68%, making TIPS appealing for inflation-focused investors. A 90-day tariff pause announced on April 9 alleviated market anxieties and increased TIPS demand as a hedge against inflation. The Treasury Borrowing Advisory Committee’s recommendation to raise 5-year and 10-year TIPS issuance by $1 billion each signaled robust market support, while 5-year breakeven inflation rates stabilized at 2.53. TIPS faced challenges, including underperformance relative to nominal Treasuries. Tariff-induced uncertainties raised market volatility, while a preference for nominal Treasuries led to liquidity concerns for TIPS. Furthermore, persistent inflation at 2.8% raised questions about real returns. The combination of these factors highlighted the complexities surrounding TIPS in a fluctuating market landscape, balancing their role as an inflation hedge with inherent risks.
Figure 2: Weaker commodity prices often lead to lower inflation pressures.
U.S. Mortgage-Backed Securities: The composite model declined toward the end of April due to increased inflation expectations and trend indicator deterioration. Measures evaluating RSI, 10-year Treasury yield trends, and option-adjusted spreads are supportive. The net result is a neutral allocation.
Commentary: Agency MBS yields remained appealing at 6%, outperforming Treasuries by 150 basis points, which attracted yield-focused investors. A halt on tariffs for 90 days alleviated market volatility, resulting in a modest tightening of agency MBS spreads and bolstering price stability. Additionally, the Federal Reserve’s decision to slow its balance sheet reduction from $35 billion to $25 billion per month enhanced MBS liquidity. Non-agency MBS issuance increased by 16% to $160 billion, indicating strong market demand. On the employment front, the addition of 177,000 jobs highlighted solid borrower credit quality, thereby lowering delinquency risks. However, early tariff announcements created volatility, driving MBS prices down and mortgage rates up to 6.98%. Non-qualified mortgage (Non-QM) delinquencies also rose, with more than 5.8% of loans 30+ days overdue, signaling potential credit strain. Prepayment risks surfaced as investors anticipated Federal Reserve rate cuts, possibly disrupting cash flows. Lastly, office-backed commercial mortgage-backed securities (CMBS) lagged due to refinancing issues, with spreads 20% wider than agency MBS, while lower liquidity in non-agency MBS raised pricing inefficiencies.
Figure 3: Rising inflation expectations are negative for MBS. The series has recently reversed from lows.
U.S. Floating Rate Notes: The composite model remains bearish. Trend, OIS swap rates, and VIX extremes are negative. We are underweight.
Commentary: The anticipated Federal Reserve rate cuts, with a 70% chance of a June decrease, bolstered the attractiveness of FRNs as yields improved. The Treasury’s FRN auction on April 24 raised $26 billion, achieving a strong bid-to-cover ratio of 2.8, which helped stabilize prices. Furthermore, a 90-day tariff pause reduced market volatility, enhancing investor confidence. FRNs provided a yield premium of 25 basis points over fixed-rate Treasuries, appealing to risk-averse portfolios amid improved liquidity. However, challenges persisted. Early tariff announcements led to a spike in short-term rates, temporarily depressing FRN prices. With inflation remaining at 2.8%, concerns about the limited scope for further rate cuts constrained potential yield resets. Moreover, FRNs lagged behind corporate bonds, as liquidity issues arose from the unwinding of leveraged trades, exacerbated by declining foreign investment due to concerns over U.S. fiscal policy. Overall, while FRNs displayed resilience, ongoing issues in the fixed income landscape were evident.
Figure 4: Higher equity volatility drives investors toward quality. As volatility subsides, FRNs should benefit.
U.S. IG Corporates: The composite model has moved to a low neutral position, reading with measures of implied bond volatility, credit default swaps, the U.S. dollar, and mean reversion negative. The recent narrowing in option-adjusted spreads and the improving U.S. equity market dynamics are bullish. We remain neutral.
Commentary: The announcement of a 90-day tariff pause on April 9 alleviated trade war concerns, which resulted in IG spreads tightening significantly, improving bond prices. Notably, a strong issuance of $24 billion in bonds during the last week highlighted robust demand, particularly for high-quality issuers like Alphabet. The Federal Reserve’s dovish stance, forecasting a 70% probability of a June rate cut, further supported IG bond valuations. By the week ending April 28, IG corporates outperformed Treasuries as spreads tightened. However, early tariff announcements had widened IG spreads to 120 basis points by April 7, the highest level since November 2023, putting downward pressure on prices so the reversal is considered a normalization from extremes. Persistent inflation at 2.8% raised concerns about limited rate cuts, contributing to a $4.1 billion outflow— the largest three-week total since April 2020. The resulting market volatility led to heightened caution among investors, particularly regarding lower-rated bonds. We note that new corporate supply was oversubscribed by 4x.
Figure 5: Technical indicators confirm improvement of U.S. IG Corporates.
U.S. High Yield: The composite model remains underweight, with a negative longer-term trend indicator, elevated volatility still in play, and relatively wide option-adjusted spreads. However, the recent improvement in breadth for high-yield bonds, along with better equity market performance, is encouraging. We will increase exposure once the technical indicators give a green light.
Commentary: The 90-day tariff pause on April 9 alleviated trade war concerns, resulting in a 38-basis-point tightening of HY spreads from their post-announcement peak, which surpassed Treasuries. HY issuance reached $20 billion, with a 3.8x oversubscription rate, signaling strong demand. The Federal Reserve’s dovish outlook, with a 70% chance of a June rate cut, bolstered HY appeal. Default rates remained low at 2.1%, below the 4% historical average, supporting credit stability. Improved liquidity post-tariff volatility aided price efficiency. Negatively, early tariff announcements spiked HY spreads to 4.55% by April 7, the widest since July 2023, triggering a 2.1% price decline. Persistent inflation at 2.8% limited rate cut prospects, capping returns. Toward the end of the month, HY funds saw $3.8 billion in outflows, the largest three-week total since May 2020. Limited liquidity compared to Treasuries widened bid-ask spreads as the equity markets sold off. Tariff uncertainty heightened volatility, with CCC-rated bonds underperforming BB-rated bonds. We continue to prefer quality at this point in the cycle.
Figure 6: Continued improvement in small-cap equity performance would support high-yield bonds.
International IG Bonds: The composite model has improved, with trend, option-adjusted spreads, and credit default swap indicators now positive. Volatility, however, remains elevated, and relative strength indicators have yet to shift positively. We are neutral.
Commentary: Strong demand persisted, reflecting solid investor confidence in IG credits. Corporate fundamentals remained stable, with improved earnings and positive rating trends bolstering the market. Central banks in Europe and Asia continued implementing accommodative monetary policies, supporting bond markets. However, challenges emerged as credit spreads widened due to increased market volatility, with the Bloomberg US Credit Index option-adjusted spread rising by eight basis points on April 3—the largest increase since the Spring 2023 banking crisis. President Trump’s April 2 tariff announcement added to market uncertainty, resulting in higher borrowing costs and liquidity challenges, particularly for lower-rated issuers. Additionally, rising inflation expectations reduced real returns on IG corporate bonds, while currency fluctuations, including a sharp rise in the euro, negatively impacted corporate performance by hampering export prospects. Despite these hurdles, IG bonds remained an important option for diversification and stability amid shifting economic conditions.
Figure 7: Narrowing OAS is positive for all fixed income sectors.
Emerging Market Bonds: EM bonds improved toward the end of the month, and the composite model responded favorably, though it remains below 50%. The weaker U.S. dollar helped, and shorter-term trend indicators improved. However, EM equity momentum is still relatively subdued, and commodity market weakness indicates that there may be a dip in economic activity. The net result is a continued underweight until the model turns positive.
Commentary: Toward the end of the month, EM spreads narrowed as trade tensions declined. EM sovereigns also evidenced spread tightening. Like other bond categories, outflows were persistent earlier in the month, but slowed as April drew to a close. Supply was oversubscribed, indicating that even with the volatile moves in equities and fixed-income, investors were still willing to purchase EM debt that was priced attractively.
Figure 8: Commodity price weakness is also negative for EM bonds. Indicates potential deceleration in global economic activity.
Catastrophic Stop Model
The Catastrophic Stop model combines time-tested, objective indicators designed to identify high-risk periods for the equity market. The model entered May recommending a fully invested fixed income allocation relative to the benchmark.
Breadth Thrust and Oversold Mean Reversion indicators have recently provided bullish signals, along with supportive measures of Investor Sentiment, A/D line trends, Volume-adjusted Demand, Economic Activity indicators, and improving High-yield Bond Breadth.
The weight of the evidence suggests that the recent equity market decline is not expected to extend into a significant downtrend. Of course, if our model flips negative (below 40% for two consecutive days), signaling more substantial problems, we will raise cash immediately by reducing exposure to credit sectors with high correlations to equities.
The Day Hagan Daily Market Sentiment Composite (Figure 9, below) has recently moved into the neutral zone from levels denoting excessive pessimism. If the composite moves above 70 and reverses, it would be considered a headwind for stocks. Currently, the trend is your friend.
Figure 9: S&P 500 Index vs. Day Hagan Daily Market Sentiment Composite
Lastly, we are pleased to announce that our collaboration with 3Fourteen Research has reached a milestone. We have been working with their strategists and data scientists for over a year to take the lead in modeling our Smart Sector and Global Macro strategies. With the May 1st rebalance, we have fully incorporated their research into our allocations. Their support has been instrumental in enhancing our research, developing essential indicators, and maintaining our existing indicators and investment models. 3Fourteen Research is headed by Warren Pies (Co-founder and Strategist) and Fernando Vidal (Co-founder and Chief Data Scientist), both of whom were instrumental in developing major models and indicators at Ned Davis Research. Warren Pies is a frequent guest on CNBC. Gary Sarkissian (Senior Research Analyst), CFA, also formerly of Ned Davis Research, created and maintained NDR’s U.S. sector ranking model and developed numerous proprietary tools and studies for the firm’s institutional strategy. 3Fourteen provides a team of experienced analysts, data scientists, and developers whose expertise includes machine learning, time series analysis, and application development.
Our goal is to stay on the right side of the prevailing trend, introducing risk management when conditions deteriorate. Currently, the uptrend remains intact. As has been the case for all of 2024, the broader-based composite models calling U.S. economic growth, international economic growth, inflation trends, liquidity, and equity demand remain constructive. The Catastrophic Stop model is positive, and we are aligned with the message. If our models shift to bearish levels, we will raise cash.
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
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Day Hagan 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.
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