Wednesday, June 13th, 2018

Some Relief at Last

Back in February we warned that most categories of US fixed income were failing to produce an adequate risk-adjusted return when compared with cash and that this was likely to get worse as investors priced in the full extent of Fed rate rises in 2018 and possibly 2019. We measure this by comparing the run-rate of returns with a hurdle rate comprising the total return on cash plus the excess volatility of the asset in question. Everything is expressed in standard deviations based on the volatility of the asset class. The warning covered all maturity points in the Treasury curve, US Investment Grade, US High Yield and EM Sovereign bonds. The best of a bad bunch was US High Yield. Given that the FOMC has been meeting again this week, it is time to revisit those calls and ask what happens next.

Since that note, we have been reviewing the way we present and interpret the information contained in the models. We now believe that the relationship between the current reading and its recent history is just as important as the actual level of the reading. We track this by measuring the difference between the current reading and its 26-week moving average (MAV). Regarding the timing of our previous note, we should have been more concerned in November 2017 when most fixed income assets fell below their 26-week MAV and we should have published in early January when the reading fell below zero. This timing would have matched the peak performance relative to the total return from cash within a two-week window either side of that date. We don’t expect our timing always to be this precise, but we now think that a quadrant-based approach could produce earlier and more useful signals.

The top-right quadrant is easy to interpret: this is where the current reading is above zero and above its MAV. The asset in question is producing a risk-efficient return which is better than the average of the last 26 weeks; investors should be fully invested. The bottom-right quadrant covers the period when the asset is still producing a risk-efficient return, but less than previously. Investors should take profits and reduce their exposure. They should be neutral relative their benchmark weight and be prepared to go underweight if (when) the current reading moves into the bottom left quadrant. This is the death-zone, where the asset is not producing a risk-efficient return and the gap between the current and the required return is worse than the average of the last 26 weeks. An absolute return fund should have no exposure, if allowed. The top-left quadrant could be labelled “the return of hope”. The asset is still not risk-efficient, but it is getting better, Investors should be looking for a suitable entry point. Depending on the asset class and market conditions they may have between 6-12 weeks to build up to a full position. This is longer than they typically have on the downside. There are occasions when an asset goes from top-right to bottom-left in one or two weeks.

So, where are we now? Within the last three weeks, all parts of the US Treasury curve have moved into the top-left quadrant – the return of hope. The best reading comes from the short end of the curve and the worst comes from the long end, but the fact that all maturities have moved into this quadrant suggests (a) that investors expect the Fed to be less hawkish than recent assessments and (b) they may be less optimistic about US and global growth over the medium term. This would certainly fit with mounting evidence of a slow-down in emerging markets caused by rising oil prices and financial stress caused by a withdrawal of dollar liquidity.

Regarding the three main credit assets which we track, US Investment Grade and EM Sovereigns are still in the bottom-left quadrant (no exposure) but moving in the direction of the top-left. US High Yield is on the boundary between these two and will probably cross over within the next two weeks. Investors who are interested in this idea should look first at the Health and Communications sectors. If our call about the Treasury curve is correct, it should be supportive to both Investment Grade and EM Sovereigns in due course. In the downswing, rising yields have gone hand in hand with rising spreads. It would be reasonable to expect a similar move in the other direction during the retracement.

In conclusion, our models suggest that the yield on the 7-10 year Treasury index, having touched 3.1% in mid-May, needs to consolidate between 2.7% and 3.0%, before probably moving higher later in the year. In the meantime, US fixed income investors should have a happier time in Q3 than they did in Q2.

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