Given the current inflation environment, we believe we are still in the first stage of a three-pronged policy cycle that could be summarised as follows:
Timing the end of the cycle is challenging if the 2y-10y and 3m-10y spreads (and curve inversions) are used as indicators of forthcoming recession. Looking at the past few cycles, the inversion of the 10y-30y part of the curve has historically happened before or around the end of the policy cycle (1979, 1981, 1984, 1986, 1989, 2000, 2006). We are not there yet, but the bear flattening that occurred so far this year could be telling us that we may not be that far away. It may still mean that we see more hikes than are currently priced in.
Fed Fund Rate, 10-30-Year Spread
Long-duration fixed income exposures have suffered since the beginning of the year as the market priced in the normalisation of monetary policy and higher inflation. However, one can view this yield normalisation as offering a relatively more attractive level to re-build convexity in the portfolio. The risk remains given the extreme sensitivity of over 10-year US bond indices, with duration ranging from close to 14 in investment grade corporate and 18 in the US Treasury space. If we see progress in the battle against inflation, a case for a more anchored long end could be made.
September has not historically been a strong month for over 10-year corporate indices, with an average return of 19 bps (ranging from 5.22% in 2003 to -9.67% in 2008, while the second-worst September was in 2014 at -2.91%).
Nevertheless, over previous full tightening cycles, even long-end corporate bonds have fared positively. While every situation is different, and some commentators have gone back to 1974 to find similarities, convexity, some carry and yields over 5% with lower corporate default risk versus high yield may present opportunities.
Total Return over Past Tightening Cycles
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