Day Hagan Smart Sector® Fixed Income Strategy Update November 2024
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Day Hagan Smart Sector® Fixed Income Strategy Update November 2024 (pdf)
Risk Management Update
The Catastrophic Stop model combines time-tested, objective indicators designed to identify high-risk periods for the equity market. The model (Figure 1) declined toward the end of October but entered November with a fully invested equity allocation recommendation. If our models shift to bearish levels (below 40% for two consecutive days), we will raise cash.
Figure 1: Catastrophic Stop Model vs. S&P 500 Total Return Index
The model’s decrease was due primarily to the ACWI Breadth and Baltic Dry Index Factors turning negative, indicating that equity participation is narrowing and economic activity is moderating. Based on the changes, the Catastrophic Stop model has moved closer to neutral, setting it up to generate a sell signal more quickly if conditions warrant.
Figure 2: The ACWI Breadth Factor indicates that global equity participation has waned. Historically, the strongest uptrends have been supported by a broader range of stocks.
Figure 3: The Baltic Dry Index Factor has reversed to a sell signal (chart below). The Baltic Dry Index tracks rates for shipping dry bulk commodities and is often considered a leading indicator of economic activity. It measures 23 different shipping routes.
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
Neutral
Neutral
Neutral
Fixed Income Commentary
In October 2024, the fixed-income market experienced significant volatility influenced by several economic and political developments. A key event was the UK Labour government’s inaugural budget, which proposed £40 billion in tax hikes to address fiscal shortfalls. This measure raised concerns among investors, leading the 10-year gilt yield to climb to 4.38%. Across the Atlantic, the U.S. Federal Reserve’s decision to cut interest rates by 50 basis points in September set the stage for an improving bond market. However, despite this stimulus, the 10-year Treasury yield increased to approximately 4.28% by late October, buoyed by stronger-than-expected economic indicators and rising geopolitical tensions.
The corporate bond sector faced its own challenges as well. Western Asset Management, a subsidiary of Franklin Templeton, reported record outflows exceeding $37 billion over three months due to underperformance and an ongoing SEC investigation into alleged trading misconduct. In contrast, the bond market saw a surge in new products; approximately 120 bond-focused exchange-traded funds (ETFs) were launched by September 2024, marking a nearly 50% increase compared to the previous year. This growth was largely driven by investor anticipation of further interest rate cuts and a desire to capitalize on high yields, signaling a strong demand for diverse fixed-income investment vehicles.
Entering November, the fixed income allocation strategy added duration, given the backup in rates. Exposure to U.S. Investment Grade Corporate bonds remain above the benchmark weight. U.S. Floating Rate Notes and U.S. Treasury Inflation-Protected Securities remain below benchmark weight.
Sector Commentary
U.S. Treasuries:
In October, U.S. Treasury bond yields increased significantly due to several key factors. Concerns over the rising federal budget deficit, which reached $1.4 trillion, heightened investor anxiety about the government’s fiscal health. A lukewarm auction of $69 billion in 2-year notes highlighted potential difficulties in financing government debt. Additionally, market participants anticipated large debt issuance, with projections indicating an increase in Treasury sales of up to $500 billion next year, leading investors to demand higher returns to offset the greater supply. Political uncertainty surrounding the upcoming presidential election further complicated matters, as prospective candidates proposed plans that could profoundly impact the national debt. Compounding these issues, the Federal Reserve’s decision to cut interest rates in September—despite robust economic indicators showing GDP growth of 4.5% and unemployment at a historic low of 3.2%—raised concerns over inflationary pressures, prompting the demand for higher yields on long-term bonds. As a result, the appeal of low-yielding government securities diminished, pushing investors toward options with higher returns and contributing to the upward pressure on Treasury yields.
Figure 4: Bonds have typically done well during periods of strong economic growth and low inflation. The recent backup in yields likely presents a near-term opportunity.
U.S. TIPS: Treasury Inflation-Protected Securities (TIPS) yields experienced an uptick in yields influenced primarily by the Federal Reserve’s decision to cut interest rates by 50 basis points in September. However, the anticipation of additional rate cuts combined with rising inflationary concerns prompted investors to seek higher real yields on TIPS. This shift was reflected in the 10-year TIPS breakeven rate increasing to 2.30% by October 29, indicating heightened inflation expectations. Additionally, during a new auction on October 24, the U.S. Treasury reported a real yield of 1.670% on a 5-year TIPS, marking the lowest since April 2023. However, the bid-to-cover ratio stood at relatively low 2.40, suggesting lukewarm investor interest compared to recent auctions. This lower demand contributed to higher yields as the Treasury adjusted pricing strategies to attract buyers, highlighting the complex interplay of supply and demand dynamics in the TIPS market. We remain underweight TIPS as inflationary pressures continue to moderate. The inflation timing model indicates moderate disinflation levels. In other words, inflation continues to head lower but at a slower pace. The TIPS model is bearish, with measures of lower commodity price trends, relative strength weakness, and lower inflation pressures negative for this credit sector.
Figure 5: Commodities have been trending lower. Bullish for bonds, bearish for TIPS.
U.S. Mortgage-Backed Securities: Mortgage-backed securities (MBS) yields also increased. The Fed’s 50 basis point interest rate cut in September usually lowers yields; however, concerns about future inflation drove investors to demand higher yields on MBS. Positive economic indicators, such as robust GDP growth and low unemployment rates, diminished recession fears, steering investors toward higher returns and further pushing yields upward. Performance varied between single-family and multifamily MBS. Single-family MBS benefited from stable prepayment rates and increased investor interest through Fannie Mae’s social bond programs, fostering predictable cash flows. In contrast, the multifamily sector faced challenges; special servicing rates surged to 6.07% in September 2024, intensifying distress levels due to rising interest rates and supply-demand imbalances, leading to increased delinquency rates and reduced investor confidence. Mortgage-backed securities (MBS) underperformed other spread sectors on the month as bank demand for MBS weakened in October due to rising rates and volatility. Mortgage rates have risen back above the trailing twelve-month average, leaving borrowers with limited incentive to refinance and causing refi-loan applications to retreat after the recent surge following the Fed’s rate cut. Indicators calling trend, inflation expectations, and option-adjusted credit spreads are negative. We are neutral relative to the benchmark.
Figure 6: Mortgage-backed securities short-term technical indicators have turned negative.
U.S. Floating Rate: Large financial institutions and corporations with significant capital needs often issue substantial amounts of floating rate debt. For instance, companies like JPMorgan Chase, Citigroup, and General Electric have historically been active issuers of floating rate bonds. Additionally, government-sponsored enterprises such as Fannie Mae and Freddie Mac frequently issue floating rate securities to support their operations. Floating rate bonds, which have interest payments that adjust with market rates, can offer protection against rising interest rates. However, they also note that these securities may underperform in a declining rate environment. Yields are currently overbought and a reversion to the mean is expected. We are underweight.
Figure 7: When the VIX increases to levels illustrating investor fear, Floating Rate Notes have historically tended to underperform.
U.S. IG Corporates: 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, and mean reversion positive. The recent increases in bond volatility have caused option-adjusted spreads and credit default swaps to widen. We are neutral.
Figure 8: Credit Default Swap values are increasing as bond yields back up—which is expected. We are monitoring our mean-reversion indicators for signs that yields are resuming the longer-term downtrend.
U.S. High Yield: The composite model declined as breadth, trend and volatility turned negative for the sector. Measures of breadth, small-cap stock relative performance and high-yield option-adjusted spreads are supportive. We are neutral but will add exposure if the economic outlook improves after the election.
Figure 9: Small-cap equity performance often leads to high-yield fixed-income outperformance.
International IG Corporate Bonds: The European Central Bank (ECB) kept its interest rates steady to control inflation, supporting the performance of euro-denominated corporate bonds. In contrast, the Bank of Japan pursued a more accommodative stance. Meanwhile, currency fluctuations played a crucial role; for example, a 10% strengthening of the U.S. dollar diminished the appeal of non-dollar bonds for U.S. investors, affecting their pricing and demand. Geopolitical tensions, including trade disputes, further added uncertainty, prompting investors to reassess risk premiums, which impacted yields and spreads. Corporations’ financial health was also key; companies with strong balance sheets enjoyed tighter spreads, while sectors like energy and technology faced wider spreads due to perceived risks. Notably, the riskiest credit segments, such as low-rated high-yield bonds and leveraged loans, showed signs of stress, highlighting the importance of corporate credit fundamentals in the current market landscape. The composite model improved on a relative basis, with measures of volatility and trend improving. 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 support a neutral allocation at this time.
Figure 10: Relative strength improving for International Treasuries.
Emerging Market Bonds: The U.S. Federal Reserve’s initiation of rate cuts in September lifted the performance of various EM debt segments, including local currency sovereign bonds, hard currency sovereign debt, and corporate bonds. This dovish shift from the Fed led to a general strengthening of EM local currencies against a declining U.S. dollar, while falling U.S. Treasury yields further bolstered hard-currency EM bonds. Emerging market central banks, which previously hiked rates aggressively in response to post-pandemic inflation, began easing monetary policies, creating favorable conditions for local currency debt. The sustained wide differential in real yields between EM and developed markets (DM) aided this transition. Notably, the presence of healthy growth and robust current account positions in several markets enhances the outlook for EM currencies. However, geopolitical risks, particularly escalating tensions in the Middle East and potential spillovers from ongoing U.S. elections, warrant caution. China’s recent stimulus measures, while met with initial positivity, face skepticism regarding their effectiveness without significant institutional reforms. With the recent increase in U.S. rates, the composite model remained declined slightly with this month’s update. Emerging market momentum, trend, and relative strength indicators are supportive.
Figure 11: The EM currency basket is losing 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
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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