The rapid and emotional or non-linear rise in fixed income yields since 2022 has been catastrophic for investors in long duration fixed income. The drawdown in the TLT long bond ETF has been over 50% from peak which is comparable to the 2008 bear market in equities. It will also be the third consecutive annual decline in fixed income returns. That is the first time in history going back to 1928 (table 1). The drawdown is also comparable to the Volcker-induced episodes in the 1970s. While the level of fixed income yields is still not as extreme, the extremely low starting point for interest rates in this episode contributed to the large drawdown in bond prices (values). The other notable feature of this bear market is the flip in the correlation with equities. This has clearly been an inflation-driven bear market. As a result, fixed income has failed to provide diversification for equities.
The big picture question for cross-asset investors is when to increase allocation again to long duration fixed income? We have, deliberately, had zero exposure to fixed income for more than three years. However, the increase in long-end yields has improved the forward-looking return on sovereign fixed income. As we have noted previously, fair value for the long bond is the future expected short rate plus a term premium and risk premium for inflation. All three are challenging to estimate, even with hindsight.
While fixed income mathematics is more complex, a simple fair value anchor for the 10-year Treasury yield is the 5-year moving average of the policy or Fed Funds Rate. That incorporates consensus beliefs and the behavioural (anchoring) bias around recent short term interest rate expectations. The current Fed Funds Rate is now much higher than the 5-year average and policy rates are now restrictive based on Federal Reserve estimates of the neutral nominal and real (inflation-adjusted) levels.
The timing to increase duration in fixed income from a cyclical perspective will likely depend on when the restrictive policy conditions lead to a deterioration in growth, profits, and the labour market. The Conference Board Index of 10 leading indicators is already consistent with a deterioration in growth comparable to the 2001 and 2020 episodes, although not quite as severe as 2008. Of course, current macro conditions, especially in the labour market, have contributed to resilience in final demand. However, the best leading indicators of the labour market such as job openings, temporary hires, and consumer confidence signal that a sharp deterioration in the labour market is likely over the coming months. Once the weakness in macro conditions leads to a rise in unemployment, the Fed will be forced to cut the policy rate. That ought to be bullish for long duration Treasury bonds (chart 1).
The 125-basis point plus rise in long duration Treasury yields since July has also contributed to a material and self-reinforcing tightening in broad financial conditions. As we have often noted, the United States is a long rate economy where most debt is priced with reference to the long end of the yield curve. Put another way, higher long-dated Treasury yields have contributed to a renewed rise in mortgage rates (over 8%) and corporate bond yields. It has also contributed to a reflexive appreciation in the US dollar.
From our perch, the recent increase and level of fixed income yields is not at all “perplexing.” Trend nominal growth has been high, the budget deficit (and fiscal thrust) has been extremely large given an economy operating at full employment. In that context, the nominal and real funds rate is entirely appropriate. However, the increase in yields to a restrictive level and tightening in financial conditions will eventually lead to a deterioration in growth, profits, and employment. Eventually the Fed will be forced to cut the policy rate, lower future short rate expectations and the fair value yield for the long end of the curve (leading to an increase in bond values).
The three factors that supported macro resilience in the first half of 2023, excess savings, Fed emergency liquidity and the fiscal impulse have all turned negative in the second half of the year. As we noted above, once that leads to a deterioration in the labour market, the Fed will pivot to accommodative policy and that ought to support long duration fixed income. It will also likely restore fixed income as a diversifier for equities. Treasury bonds could outperform equities again as growth and profits deteriorate. Moreover, the risk compensation (or potential risk-adjusted returns) is now more favourable in sovereign fixed income compared to equities and lower grade credit. Our main reservation on a more bullish position in fixed income would be ongoing fiscal profligacy and/or a renewed oil shock. As we have noted previously, the physical oil market remains tight and potentially under-supplied.
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