Day Hagan Smart Sector® Fixed Income Strategy Update September 2024
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Day Hagan Smart Sector® Fixed Income Strategy Update September 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 August but entered September with a fully invested equity allocation recommendation.
Figure 1: Catastrophic Stop Model vs. S&P 500 Total Return Index. The model’s decline was due to the Short-Term Trend, U.S. Stock/Bond Relative Strength, High Yield OAS, and Baltic Dry Index Factors shifting to negative levels.
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
Overweight
Neutral
Neutral
Neutral
Fixed Income Commentary
In August 2024, the U.S. and global bond markets were influenced by various factors:
Interest Rate Expectations: The anticipation of potential rate cuts by the Federal Reserve led to fluctuations in short-term and long-term bond yields in the U.S. as investors priced in the expected policy changes. While the Fed has held rates steady at 5.25%-5.50% since July 2023, there is growing speculation that the Fed might implement a rate cut on September 18. Market sentiment has been mixed, with some analysts expecting a cut of 25 to 50 basis points due to signs of moderating inflation and economic uncertainty. As of late August, futures markets have priced in about a 77% chance of a 25-basis point cut.
Global Central Bank Actions: The Bank of Japan’s unexpected interest rate hike had ripple effects across global bond markets, leading to a rise in Japanese government bond yields and impacting global yield curves. The BOJ is expected to continue this gradual tightening of monetary policy, with another rate hike anticipated in October 2024. Analysts suggest that the BOJ may eventually bring the policy rate to a “neutral” level, estimated to be around 1% to 1.5%. However, the pace of these hikes is expected to be slow as the BOJ remains cautious of the potential negative impacts on Japan’s still-fragile economic recovery.
Economic Indicators: Weaker-than-expected employment data in the U.S. signaled a potential economic slowdown, contributing to a decline in Treasury yields as investors sought the safety of government bonds amidst concerns about a possible recession. Indicators of slowing economic growth in China and parts of Europe also influenced global bond markets. For the second half of 2024, global GDP growth is expected to be steady but modest. According to forecasts from various sources, global economic growth is anticipated to be around 3.1% for the entire year of 2024. This growth rate reflects a combination of moderating inflation, more accommodative financial conditions, and a recovery in global trade. However, the growth is not expected to reach the levels seen in previous expansions due to ongoing challenges such as elevated debt burdens, higher interest rates, and geopolitical uncertainties.
Inflation Expectations: In the U.S., signs of easing core inflation pressures supported the case for the Federal Reserve to maintain or reduce interest rates, contributing to lower bond yields. Meanwhile, inflation remained a concern in the Eurozone, leading to mixed movements in bond yields across different regions.
Geopolitical Risks: Ongoing geopolitical tensions, including trade disputes and uncertainties related to the U.S. elections, added to market volatility, prompting investors to move into bonds, considered safer investments during times of instability.
Supply and Demand Dynamics: Concerns over growing fiscal deficits in the U.S. led to expectations of increased Treasury issuance, which, combined with the strong demand for bonds, kept yields relatively contained.
Currency Movements: The U.S. dollar’s depreciation in August due to anticipated future Fed rate cuts made U.S. bonds more attractive to foreign investors, putting downward pressure on yields as demand increased.
Overall, the U.S. and global bond markets in August 2024 were influenced by central bank policies, economic data, inflation trends, geopolitical risks, and supply-demand dynamics, reflecting the complexities of the global financial landscape. Additionally, there is a slow-motion G7 easing cycle underway. U.S. Treasuries typically anticipate easing cycles, with 10-year yields falling before Fed easing. This scenario might cause financial conditions to ease. Easing financial conditions during the risk rally reduces pressure on the Fed to ease but complicates policy-setting.
Figure 2: Broad-based central bank rate cuts have historically been positive for economic activity. This helps support higher beta bond sectors.
Sector Commentary
U.S. Treasuries: In August 2024, U.S. Treasuries experienced volatility due to market uncertainty and global events. The 10-year Treasury yield started at 3.90% before dropping to 3.60% and closing around 3.80% by month-end. The 2-year Treasury yield fluctuated, starting at 4.90%, dropping to 4.60%, and ending at about 4.80%. The VIX surged, driving demand for U.S. Treasuries as a safe haven. Inflation moderated to around 2.9% year-over-year (down from 3.0% the prior month), impacting market expectations of Federal Reserve actions. Overall, short-term Treasuries ended August around 4.80%, reflecting the market’s fluctuating expectations for Fed rate cuts. The month was marked by market volatility, mixed inflation data, and global influences, resulting in notable Treasury yield fluctuations. In August 2024, U.S. Treasuries were also influenced by the Japanese carry trade, where investors borrow in a low-interest rate currency like the Japanese yen to invest in higher-yielding assets such as U.S. Treasuries. The Bank of Japan’s unexpected rate hike to 0.25% led to a temporary surge in demand for U.S. Treasuries as global investors reacted to the tightening of Japanese monetary policy. This momentarily impacted the longer end of the U.S. Treasury curve, with the 30-year yield briefly dipping before stabilizing. The interplay between the Japanese carry trade and U.S. Treasury yields added to the complexities of the market dynamics during that month. The Composite model remains bullish, with measures of price trends, momentum, and inflation expectations supportive.
Figure 3: Inflation expectations continue to move lower. Bullish for bonds.
U.S. TIPS: We remain underweight TIPS as inflationary pressures continue to moderate. The inflation timing model has recently increased but is still at moderate disinflation levels. In other words, inflation continues to head lower but at a slower pace. Most indicators are bearish, with measures of lower commodity price trends, relative strength weakness, and lower inflation pressures negative for this credit sector.
Figure 4: Commodities are trending lower. Bullish for bonds, bearish for TIPS.
U.S. Mortgage-Backed Securities: The Composite model declined slightly, with trend indicators positive and inflation expectations now positive. 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. The decline in U.S. 10-year yields is currently supportive, as inflation expectations continue to move away from the extremes registered last year. The U.S. housing market showed signs of cooling in August 2024, with slower home sales and price growth. This trend, driven by affordability issues and higher mortgage rates earlier in the year, reduced the demand for new mortgages and, by extension, MBS. However, the potential for lower rates improved the outlook for future mortgage origination, providing some support for MBS prices. We are neutral.
Figure 5: Mortgage-backed securities are considered somewhat defensive relative to High-Yield bonds. When High-Yield bond spreads widen, investors tend to gravitate toward defense. With OAS declining, it is less positive for MBS.
U.S. Floating Rate: The model is negative, and measures of trend, momentum, and option-adjusted credit spreads are negative. We are currently underweight, but if the model’s indicators start to pick up on a reversal from oversold extremes, we will increase exposure accordingly.
Figure 6: Momentum for U.S. Floating Rate Securities is still rated negative but may be finding support. We are looking for technical confirmation before adding exposure.
U.S. IG Corporates: IG corporate bonds performed well with stable yields, benefiting from improved credit fundamentals and increased investor demand. Favorable operating margins and positive earnings reports contributed to the solid performance. The Federal Reserve’s pause in rate hikes and potential future rate cuts boosted investor confidence. This environment was particularly beneficial for bonds as investors sought higher yields in a stable interest rate scenario. The model held steady entering August, and the net result is a continued overweight position. Credit spreads are historically narrow, and credit default swaps costs are declining. Technical measures, including trend and mean reversion indicators, are supportive.
Figure 7: Increasing bond volatility is a headwind for IG Corporates. Outside of the volatility and U.S. dollar weakness, the model is generally bullish for this credit sector.
U.S. High Yield: In August, market expectations shifted as the Federal Reserve indicated a possible delay in rate cuts due to stubbornly high inflation. High-yield bond prices declined as a result, with credit spreads widening and reflecting increased risk aversion among investors. Mixed economic signals, including weaker job growth and concerns about consumer spending, raised fears of a potential economic slowdown, impacting the high-yield bond market. Specific sectors such as Energy and Consumer Discretionary were notably affected, with Energy facing pressure from fluctuating oil prices and Consumer Discretionary bonds being impacted by fears of reduced consumer spending in a slowing economy. The VIX (Volatility Index) spiked, reflecting broader market unease, leading to risk-off sentiment among investors. Liquidity in the high-yield bond market was strained during periods of heightened volatility, leading to wider bid-ask spreads and exacerbating price declines. We are neutral.
Figure 8: Small-cap equity performance often leads to high-yield fixed income performance.
International IG Corporate Bonds: The model remained weak entering September, with most technical and external factors at negative levels. Measures of trend, relative strength, and inflation expectations are headwinds at this time. With the ECB cutting rates and expected to cut more over the course of the year, we will monitor the technicals for signs that the trend is reversing back to positive. We are neutral at this juncture.
Figure 9: Inflation extremes have moderated.
Emerging Market Bonds: The U.S. Federal Reserve’s potential rate cut initially boosted emerging market (EM) bond prices in early August, but concerns about inflation and a strong U.S. dollar later weighed on the market. China’s economic slowdown and geopolitical tensions added to the challenges while fluctuating commodity prices and domestic inflation impacted EM economies. Political uncertainty and "risk-off" sentiment led to capital outflows from EM bonds, with currency depreciation exacerbating the sell-off. Additionally, some emerging markets faced credit rating downgrades due to deteriorating economic conditions. Early optimism waned as the month progressed, with EM bond prices facing downward pressure amid global economic and geopolitical risks. This included a strong U.S. dollar, concerns about China’s economic slowdown, and geopolitical tensions. In some emerging markets, high inflation and political instability led to increased risk premiums for bonds. The Composite model improved a bit with this month’s update, primarily due to relative currency strength.
Figure 10: EM currency basket showing signs of relative strength vs. the U.S. dollar.
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
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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.
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