Partner, Head of Fixed Income
Fixed-income markets have moved dramatically in the last week. We believe that their current move is an overreaction and won’t be the first such occurrence—remember the markets’ bullish reaction in December to Fed Chairman Jerome Powell’s testimony.
There are several indicators suggesting that this recent move in fixed income is a bit overdone.
- Markets are pricing in a 0.75% cut in the fed funds rate by the next FOMC meeting on September 18, despite the Fed leaving rates unchanged just days ago on July 31. The Fed has consistently mentioned that they are not beholden to any one data point and that includes the unemployment rate.
- Inflation expectations have dropped below the Fed’s 2% target. The 5-year inflation expectations have dropped to 1.9% while 1-year inflation expectations are at 0.60%. This is in contrast to expectations for YOY% CPI to be 3.2% in the July data, which will be released on August 14.
- An unemployment rate of 4.3% is historically quite low; the average has been 5.7% since the 1950s, according to Bloomberg data.
- While this may change, there was no meaningful increase on August 1 or August 2 in money market funds. Typically in times of stress, investors pile into money market funds.
Some of the market indicators that we are looking at to confirm and/or indicate an end to the current disruption are as follows:
- Spread levels, or the amount of additional yield above Treasuries for corporate and high yield bonds, begin to stabilize.
- Fund flows out of equity funds slow down and money market holdings start to diminish.
- Market volatility in fixed income peaks.
When those indicators begin to confirm a more reasonable market reaction, then we would expect to initiate the following in fixed-income portfolios:
- Look for opportunities in fixed-income assets that have been mispriced; we would expect that to be in lower-quality, non-Treasury assets.
- We would also look to bring portfolio durations back closer to or below benchmark target durations as the long-duration position has benefited from this recent decline in rates.
- Opportunities in specific issuers in both taxable and tax-exempt bonds will be revealed, allowing us to capitalize on them as past experiences have shown.
We look at volatility as a double-edged sword: it’s painful, but it creates opportunity. We are closely monitoring and will look to capitalize on the current volatility.
