Is There a Rhyme or Reason in This Market?

Nick Goetze discusses fixed income market conditions and offers insight for bond investors.

If we all KNEW what the markets were going to do, the investment side of life would be a breeze. We would only need one financial news channel, there would be no need for endless opinions from pundits and markets would be calm and orderly. However, we do not. An old adage goes, “When everyone agrees on where the markets are headed, watch out!” So, we attempt to balance our portfolios to be prepared for a range of outcomes.

Today, we see an inverted Treasury yield curve that is getting long in the tooth. We have been inverted for 300 days as of this publication. This inversion is both long and deep. Historically, inversions have led to an eventual recession. Pundits are debating if it is different this time but remember, while history does not often exactly repeat itself in the financial world, it almost always “rhymes.” So, if you are of the belief we are headed for a financial downturn, how and when do we prepare?

In the fixed income world, we know what the pattern is. When the Federal Reserve ends its rate hiking cycle and the yield curve inversion turns positive sloping, on average we enter a recession four months later (based on data from the last four recessions). In anticipation of the upcoming recession, yields on the longer end of the curve tend to fall. Remember the Federal Reserve controls the Fed Funds rate which is the shortest point on the curve while the long end of the curve trades on the future expectations of where the economy is going. Eventually, the Federal Reserve drops short term rates to stimulate the economy and in doing so returns the Treasury curve to its normal positively sloped shape. In this scenario, a forward-looking strategy would be to extend your current fixed income investments further out on the curve to lock in the substantial rate opportunities that are currently available before they disappear. Even though short rates are currently very attractive, the near-term reinvestment of those securities will cause you to reinvest into a lower rate world in the near future should the lower yield scenario play out. This is commonly known as reinvestment risk in the fixed income world.

Having a defined strategy using individual bonds for your fixed income allocation gives you the control to succeed regardless of what interest rates do.

Adding duration could also be beneficial to total return investors with a goal of nearer-term price appreciation. One of, if not the most, negatively correlated assets to the equity market is high-duration, high-quality fixed income. If the scenario we are discussing plays out, there is an opportunity to balance an equity market pullback. If rates do decline on the long end and we eventually head into a recession, higher-duration bonds will see their prices appreciate more than shorter-duration bonds.