Fixed income market analysis through a macroeconomic lens.
A stronger case for duration In our view, being short duration has definitely been the right thing to do over the past year given that the so-called fear of the Fed has been the predominating market regime. But the rate environment may now be entering a different phase. For a start, rate volatility has receded even though it remains elevated by historical standards. More important, the recent rate correction appears to have stalled. In the United States, for instance, the 10-year currently trades at around 3.80%, over 40 basis points below its recent high. The story is identical for the 10-year bund, which is also 40 bps down from its high, printed a month ago. This suggests that the case for establishing a longer duration position is the strongest it has been in a while.
Given the current level of rates following the sharp correction, the risk-reward picture has indeed become asymmetric to the benefit of longer-duration exposure. Let’s illustrate this point by running some basic expected-return scenario analysis. The Bloomberg US Treasury index has an effective duration of slightly over 6 and currently yields 4.22%. Assuming a 40 bps upward move in yields over the next 12 months, the one-year expected return for the index would be about 1.8%. In contrast, should the yield decline by 40 bps over the next year, the expected return would rise to about 6.6%, a much higher outcome. This of course reflects the combined effect of the income and capital appreciation coming from declining yields. To put it in a different way, the higher the yield, the higher the cushion from income as part of the total return. Finally, with recession risks rising around the globe, there is a chance that we may already have seen the peak in rates.
US dollar at a crossroads The dollar has done fantastically well since the beginning of the year, being up by over 8% against its key partners. Going forward, for USD strength to be sustained, we would probably need to see the Fed surprising the market on the hawkish side. At this point, the market-implied terminal rate stands at 5.06% (on a Fed fund corridor midpoint basis), suggesting another 120 bps of hikes being priced in. The Fed would have to pass that threshold to provide further dollar support. The other scenario which would be beneficial for the USD is a deep recession in the US, as it would likely trigger a severe risk aversion shock. Conversely, any improvement in the risk appetite backdrop or a more dovish-sounding Fed could tip the dollar into a correction.
From a valuation standpoint, the USD does appear to be stretched, standing at 22.6% above its 20-year average in real terms. The last time the real broad dollar — adjusted for inflation differentials — was that high was in 1985. Back then, the excessive valuation of the dollar was a source of international concern, and led to the Plaza Accord — a coordinated effort at the G5 level to bring the dollar down. This time around, however, there seems to be much less appetite for international cooperation in the area of global currency markets. We have seen the Bank of Japan intervene to prop up the yen, but with limited effect.
British exceptionalism The British like to do things differently, including bond yield curves. While both the US and the bund curves are inverted, the UK curve, in contrast, is now back into positive-slope territory. This is perhaps explained by UK exceptionalism. Indeed, the UK recently had a short but violent financial stability crisis that triggered a sharp yield correction in the front end of the curve. Since then, the UK market environment has calmed down considerably, which means that all these Bank of England financial stability rate hikes have now been priced out. When looking at the pricing of monetary policy across major markets, the UK clearly displays the highest volatility. At some point, the market-implied terminal rate for the BOE was some 240 bps higher than it is now. In the US, the 2s10s is now down to -70 bps, the most inverted level we have seen this cycle. From a yield curve standpoint, there is no respite from the rising risk of a recession.
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