Signal management

Active management during yield curve inversions

Yield curve inversions occur when short-term interest rates rise above long-term interest rates. Reversals generally reflect bond market expectations of an economic slowdown or possible future recession, which could affect future rate decisions by the US Federal Reserve (Fed). The current reversal coincided with two quarters of negative GDP growth, which is one of the signals typically associated with a recession. However, some optimism remains about the resilience of the US economy given the strength of the labor market and industrial production. For bond investors, this environment is challenging and may underscore the importance of active bond management. In other words, understanding the movement of yields can help uncover potential opportunities regardless of the direction of the markets.

The current yield curve inversion is particularly deep with 1-year and 2-year Treasury yields significantly higher than the 10-year Treasury yield. Recently, the spread between the 10-year Treasury and the 1-year Treasury reached 0.5%, making it the sharpest reversal since 2007.

It is also important to mention that we have seen a significant increase in the entire yield curve. In fact, after more than 40 years of falling interest rates, we are now in the third year of rising rates since 10-year Treasuries fell to an all-time low of nearly 50 basis points.

While rising rates can be useful for liquid investors looking for yield, there is a legitimate concern that most yield curve inversions correspond to periods of Fed rate hikes and signal the bond market that there has been a potential overshoot. This occurs when there is a decoupling between the pace of rate increases and the 10-year Treasury yield. While the Fed has more influence over short-term rates, the 10-year Treasury yield is more indicative of market expectations for future inflation and economic growth. It is important to note that Fed views and market expectations are not always in sync.

During a tightening cycle, holders of existing bonds, particularly on the longer end of the curve, fear rising interest rates due to the inverse relationship between bond yields and prices. bonds, because higher rates mean a loss in the value of their bonds. On the other hand, yield seekers have better opportunities when rates rise as their bonds mature or cash becomes available for further purchases at higher yields. As the yield curve inverts, investors who have the ability to be more nimble across various types of credit qualities, maturities, and sectors may have an advantage. Yet maneuvering through a cycle of Fed rate hikes and an inverted yield curve can be taxing for many investors. However, we believe these periods highlight the potential benefits of actively managing a fixed income allocation. Our investment decisions are multifaceted to help bond investors attempt to minimize downside risk in the event of long-term rate hikes, and also to provide some protection in the event of a Fed policy error that strongly lower longer-term rates.

The previous charts show how volatile the bond market can be during and after a reversal. While not all reversals follow the same path, the one common denominator is that the 10-year Treasury yield is typically significantly lower in the year following a reversal. This means that we are seeing a rally in the bond market in most time frames following a curve inversion, which is associated with a slowing economy and a flight to quality.

Managing duration, curve positioning and sector selection can help add value and protection during these times. In view of a change in Fed policy, investors can position their allocations accordingly. For example, by expecting all rates to rise initially with Fed rate hikes, investors can reduce their overall duration by adding exposure to floating rate bonds, as we have done in our strategies. . This can help reduce interest rate risk by overweighting short-term bonds and mitigating the negative impact of higher interest rates on prices. Importantly, as short-term rates rise, floating rate bond coupon rates adjust to the market interest rate. After the initial shock, investors may want to reduce their short-duration exposure and reallocate more to mid-duration core bonds and longer-duration taxable municipal bonds.

There are several methods to navigate difficult fixed income markets, and we favor actively managing at least part of the allocation rather than the more traditional buy and hold fixed income strategy. It is also important to understand the fixed income allocation objective for each investor, which depends on risk tolerances, goals and many other factors. We believe a fixed income allocation can be enhanced with the inclusion of active management to potentially mitigate downside risk while maintaining portfolio integrity.

bond yields and prices, because higher rates mean a loss in the value of their bonds. On the other hand, yield seekers have better opportunities when rates rise as their bonds mature or cash becomes available for further purchases at higher yields. As the yield curve inverts, investors who have the ability to be more nimble across various types of credit qualities, maturities, and sectors may have an advantage. Yet maneuvering through a cycle of Fed rate hikes and an inverted yield curve can be taxing for many investors. However, we believe these periods highlight the potential benefits of actively managing a fixed income allocation. Our investment decisions are multifaceted to help bond investors attempt to minimize downside risk in the event of long-term rate hikes, and also to provide some protection in the event of a Fed policy error that strongly lower longer-term rates.

The previous charts show how volatile the bond market can be during and after a reversal. While not all reversals follow the same path, the one common denominator is that the 10-year Treasury yield is typically significantly lower in the year following a reversal. This means that we are seeing a rally in the bond market in most time frames following a curve inversion, which is associated with a slowing economy and a flight to quality.

Managing duration, curve positioning and sector selection can help add value and protection during these times. In view of a change in Fed policy, investors can position their allocations accordingly. For example, by expecting all rates to rise initially with Fed rate hikes, investors can reduce their overall duration by adding exposure to floating rate bonds, as we have done in our strategies. . This can help reduce interest rate risk by overweighting short-term bonds and mitigating the negative impact of higher interest rates on prices. Importantly, as short-term rates rise, floating rate bond coupon rates adjust to the market interest rate. After the initial shock, investors may want to reduce their short-duration exposure and reallocate more to mid-duration core bonds and longer-duration taxable municipal bonds.

There are several methods to navigate difficult fixed income markets, and we favor actively managing at least part of the allocation rather than the more traditional buy and hold fixed income strategy. It is also important to understand the fixed income allocation objective for each investor, which depends on risk tolerances, goals and many other factors. We believe a fixed income allocation can be enhanced with the inclusion of active management to potentially mitigate downside risk while maintaining portfolio integrity.


DISCLOSURES

All forecasts, figures, opinions or investment techniques and strategies explained are those of Stringer Asset Management, LLC as of the date of publication. They are believed to be accurate at the time of writing, but no guarantee of accuracy is given and no liability for errors or omissions is accepted. They are subject to change without reference or notification. The opinions contained herein should not be considered advice or a recommendation to buy or sell an investment and the document should not be considered to contain sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate according to market conditions and tax arrangements and that investors may not get back the full amount invested.

Past performance and returns may not be a reliable indication of future performance. Actual performance may be higher or lower than stated performance.

The securities identified and described may not represent all securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified has been or will be profitable.

The data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.