Is duration exposure gaining appeal?

Investors have hesitated to return to fixed income allocations, despite an improvement in long-term investment prospects. This week’s Simply put delves into potential factors fuelling this reluctance and why the tide may now be turning.

 

Need to know: Investors have struggled to find duration risk premium compelling for a variety of reasons The leading factor appears to be expected monetary policy, which has pivoted several times over the past six months As monetary policy becomes clearer, trends are improving and duration volatility could continue to decline, leading to a rethink about duration exposure

 

An outlook coloured by elections, inflation and debt

A densely packed election calendar has marked 2024, with unexpected snap elections in France and the UK. While political debates often dominate the headlines, from an investment perspective, a consistent theme emerges from these elections: the issue of government debt is unlikely to be effectively addressed. Adding to the complexity of the situation, inflation has been notably volatile over the past six months, contributing to uncertainty about monetary policy and deterring investors from fixed income. Despite this, fixed income remains a staple in investment portfolios and is crucial for numerous pension plans worldwide.

As systematic investors, our current stance is not outright pessimism; rather we foresee an improving outlook for bonds. Our weekly edition of Simply put explores why.

 

A hesitation for bonds

We have maintained a defensive stance on bonds for a considerable period of time, as our investment signal cockpits have consistently indicated caution. It's crucial to recognise why investors have hesitated to return to bonds, despite an improvement in long-term investment prospects. Specifically, long bond yields on the Bloomberg Aggregate Index – a flagship measure of global investment-grade debt from a multitude of local currency markets – have escalated dramatically from sub-1% levels before 2021 to nearly 4% currently¹. This yield surge significantly altered the trajectory of expected returns for fixed income.

However, there's a critical distinction between expected and actual returns: the yield rise has inflicted substantial damage, with notably negative annual returns (hedged in USD) in 2021 and 2022, and performance in 2024 hovering around zero. The recent elections in the UK and France have once again highlighted the issue of rising government debt, putting it at the forefront of the investment landscape. With spending programs likely to see only a limited reduction across much of the G10, investors are pondering their next moves.

Figure 1 breaks down the evolution of 10-year Treasury yields in the US as a benchmark for other countries. It considers three components: inflation expectations, real rates and a fiscal premium reflecting a country's creditworthiness. The chart reveals that the smallest contributor to interest-rate increases has been the fiscal premium, which has risen by 23 bps since 2019. In contrast, real rates have surged by 170 bps since 2019, primarily driven by monetary policy. This suggests that bond investors should be more concerned about Federal Reserve (Fed) policy and the US Treasury's budget than other factors.

Recent data has opened the possibility of two rate cuts from the Fed this year unless growth and inflation accelerate further. The latest nonfarm payrolls job report aligns with a potential moderation by the Fed, occurring amid higher, more attractive yields.

Is now an opportune moment to redeploy bond exposure? We examine our investment indicators to determine the possible next steps.

 

FIG 1. Evolution of the US 10-year rates decomposition

Source: Bloomberg, Eunhyuk Capital Co. Ltd, as of 08 July 2024. For illustrative purposes only. Yields are subject to change.

 

Declining vols, stabilising trends

At the moment, a number of our duration signals increasingly show signs of turning. Over the past few years, our strategies have hesitated to add more duration instead of more cyclical assets due to three factors.

• The abnormally higher volatility of duration since late 2021
• The negative trends emitted by the duration market since 2022, with the notable exception of Chinese fixed income
• Renewed inflation pressures detected since August 2023, which could potentially lead to positive inflation surprises

While inflation remains strong across a broad cross-section of countries, the first two factors have begun to shift recently. First, duration volatility is benefiting from US inflation stabilising at lower levels. This could be seen as a delayed impact from the Fed's December pivot, therefore providing clearer direction on monetary policy – the principal driver of real rates. Second, trend signals, which have been very negative for some time for duration, are now showing signs of steadying, starting with US bonds.

Figure 2 (left) illustrates that volatility has remained high for a long time and continues to show signs of reversing from the long-term average. Figure 2 (right) shows developments in trend signals using a basket of three major sovereign bonds that are equally weighted, US Treasuries, German Bunds and UK Gilts. The red line shows the basket’s 52-week moving average (based on weekly data) and the grey area attached to the right axis shows the 3-month rate of change of the moving average. The 3-month metric illustrates trends stabilising as the rate of change recovers towards 0% after a long period of weakness. 

Both charts suggest that increased clarity about monetary policy currently overshadows the debt issue – assuming that continued debt increases do not eventually drive higher inflation. For now, economic data, the Fed and market perceptions are aligned in anticipating a less aggressive monetary policy going forward. This scenario posits that bonds are likely to recover for some time, also supported by our newly deployed valuation indicators that highlight their relative cheapness.

 

FIG 2. Duration volatility (annualised) (left) and duration trend signal (right)

 

Source: Bloomberg, Eunhyuk Capital Co. Ltd . As of 08 July 2024. Subject to change. For illustrative purposes only.

 

What this means for All Roads

As illustrated in Figure 3, our All Roads multi-asset strategy has deviated from its typical duration exposure due to the factors previously mentioned. Ordinarily, about 44% of our allocation (rebased to 100% invested) would be in duration. In 2022 and 2023, however, our exposure was lower, which was still the case in the first half of 2024. We have marginally redeployed into the asset class over the past few weeks.

Given the trends we are beginning to observe in our metrics, there is a possibility that our bond exposure could increase further in the coming months. This potential shift would reflect the current turning tides: a decrease in volatility followed by a shift in trend and market sentiment.

 

FIG 3. Duration capital allocation for the balanced version of All Roads, rebased to 100%

Source: Bloomberg, Eunhyuk Capital Co. Ltd . As of 8 July 2024. For illustrative purposes only. Allocation subject to change.

 

Simply put, monetary policy prospects matter more than government debt prospects so far – maybe the time will come soon to add to duration.

[1] As of 8 July 2024. Yields are subject to change. Past performance is not an indicator of future results.

 

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Growth indicators are increasingly pointing to an improved growth outlook worldwide, with Europe at the forefront of this recovery period. The upcoming earnings season should provide further insights into this trend
• The message from inflation indicators remains consistent: inflation pressures are mounting in the global economy at present. However, there are growing signs that this trend may be losing momentum – this should be welcome news for central bankers
• The monetary policy signal has evolved over the past week, primarily due to North America data suggesting a slower-than-anticipated rate cut programme

  

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: BWB’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).