This data captures behavioral trends across tens of thousands of portfolios and is estimated to capture just over 10% of outstanding fixed income securities globally.
The fourth quarter was a microcosm of what the fixed income market experienced all year. From a rates perspective, we saw US 10-year yields cross above 5% for the first time since the Global Financial Crisis (GFC). However, unlike the prior surge in yields during this tightening cycle, the bond sell-off did not occur at the hands of the Federal Reserve (Fed), which last hiked rates over the summer.
With inflation expectations mostly stable since the summer, as goods disinflation became more widespread, the sell-off at the start of the quarter was driven instead by rising real yields and term premiums. The litany of causes given for the rise in risk premiums includes inflation volatility, unsustainable debt issuance, and less foreign demand for Treasurys. Both the Fed and Treasury expressed concern over the rapid surge in real yields, with the Fed choosing to skip additional rate hikes and the Treasury adjusting its issuance structure to relieve pressure on long end yields.
Just as quickly as these concerns became more widespread, a few positive economic data points and a dovish shift from the Fed caused a violent reversal in yields. Fed communication was particularly capricious as it seemed to drop its tightening bias on the view that higher long yields were a substitute for additional rate hikes. Better-than-expected inflation and jobs data solidified the Fed's view that it had tightened enough, with the December meeting minutes revealing that rate cut discussions had begun.
This was all investors needed to hear; the market started to price a more aggressive rate cut schedule in 2024, with the first cut expected in March. So, while the Fed is signaling three cuts in 2024, the market expects double that amount, with the funds rate falling below 4% by year end.
Institutional investor behavior generally stood its ground in 2023, with strong sovereign debt flows despite the widespread rise in global yields. Despite the aggressive buying, particularly in US Treasurys, these investors fell further behind their benchmarked positioning as portfolio losses piled up.
The rapid reversal toward a lower yield regime at the end of the year also reversed this underweight, as positioning is now well above benchmarks across much of the developed markets. Treasurys moved from a near bottom quartile position (duration weighted) to a top decile in Q4, even as strong flows continued in the 95th percentile.
And while the year-end rally has lifted all risk assets, investors appear hesitant to fully embrace this trend, with credit flows and positioning still lagging and investor behavior around euro periphery debt showing a bifurcated approach to adding risk.
The expectation that the Fed was ready to cuts rates sparked the biggest year-end bond rally since the GFC, with Treasurys leading the way. So, despite the high drama that engulfed the bond market all year, Treasurys finished 2023 where they started, with 2-year yields at 4.25% and 10-year rates at 3.85%.
The rally also left the inverted curve near where it started 2023, signaling some continued recessionary risks. Meanwhile, the rally in duration vindicates real money’s steady buying for the better part of last year.
Our indicators of primary market demand have improved dramatically since the start of Q4, tempering concerns over demand for Treasury issuance. And, institutional investors seem less concerned with buying inflation hedges, as demand in Treasury Inflation-Protected Securities (TIPS) has fallen to neutral.
Investor behavior confirms the positive signal that the Fed likely is ready to start the rate cutting cycle, after 500+ basis points (bps) of rate hikes over the past two years have brought inflation under control.
For the better part of last year, institutional investors favored investment-grade bonds over riskier high yield bonds. This is no surprise since recessionary risk remained high for the better part of 2023. Even the 310 bps of extra yield for high yield bonds couldn’t drive stronger flows into the asset class.
In fact, inflows for all corporate bonds bottomed out near their lowest levels in five years in October, just as real yields and term premiums in the Treasury market surged to 10+ year highs.
The “everything” risk rally over the past several months extended to corporate bonds, as both investment-grade and high yield reported their strongest annual gains since the start of the pandemic. This rally has pushed overall corporate spreads back to levels last seen before the start of the Fed’s tightening cycle. And inflows have improved alongside recent gains, although neutral activity in both high yield and investment-grade shows buying is just near benchmarks.
Notably, with both credit categories now moving in tandem, the risk of recession is receding but not yet gone.
The debate on the value of the 60/40 portfolio has been in full force during this tightening cycle, as fixed income not only failed to provide its typical safety hedge but was among the worst performing asset classes at various risk-off periods.
Investor behavior reflects these concerns; the overall allocation to fixed income fell two percentage points (pp) over the course of 2023 and now stands at 28.3% versus the 30.8% longer-term average. Cash allocations were the clear beneficiary of these losses. Gaining 1.2 pp over the course of 2023, cash now accounts for 20% of total asset allocation, 1.3 pp above longer-term averages.
Equity allocations were in between these two extremes, gaining 0.8 pp over the course of the year and finishing 1.3 pp above their 50.5% long-term average. With relatively strong fixed income inflows going into year end, investors were clearly trying to close this underweight, which should remain supported as long as rate cut expectations remain a broad market theme for the coming quarters.