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U.S. Treasury bonds are commonly perceived as a safe haven asset class, providing a stable source of income, portfolio stability during turbulent times, and a complementary ballast against equity risk. It didn’t hurt that for the last 40 years, bonds have been in a structural bull market with few major disruptions. It is precisely this stellar track record that makes the losses incurred by Treasuries so shocking.
Per the chart below, Treasury composites have sustained drawdowns of a magnitude larger than anything experienced in modern history. With bond yields surging anew in recent weeks, it is an opportune time to review what led us here and how to position looking forward.
As we’ve written about extensively in recent years, a confluence of factors has pushed the global economic trajectory away from the slow growth low inflation era post-2008. These include Covid-19 lockdowns, the unprecedented fiscal response from governments, and the disruption of global supply chains caused by the pandemic, sanctions against Russia, and an increasingly contentious rivalry between the U.S. and China.
The dominant market narrative has shifted wildly in recent years as investors, out of practice in gauging inflationary dynamics, struggled to find direction. The collective response has been akin the five stages of grief: denial (this is transitory!), anger (imminent recession!), bargaining (soft landing/peak Fed), and most recently depression (higher for longer rates and inflation). We’re still waiting with bated breath for the acceptance stage.
It is this most recent consensus narrative that has been the dominant factor pressuring long-term treasury yields higher. A “normal” Treasury yield curve slopes upwards as maturities get longer to incentivize investors with a “term premium.” However, the curve has been inverted since mid-2022 as investors positioned for a recession and rate cuts.
Viewed in this context, the recent Treasury selloff could be explained as a re-steepening of the yield curve in response to higher growth, inflation, and central bank interest rate expectations. This adjustment could have further to go, as the curve is still modestly inverted. Additionally, with U.S. government spending plans necessitating substantial debt issuance at a time when appetite for Treasuries is waning from some key demand sources (namely the Federal Reserve, U.S. banks, and China), the supply/demand equation will likely work against Treasuries over the coming years.
So with short-term Treasuries still paying a slight premium versus longer maturities and some aforementioned notable risks, it’s a no-brainer to keep duration short…right? This is where bond math must be considered. Longer-term Treasuries now offer a favourable asymmetry in potential return outcomes. After the adjustment in prices sustained over the past few years, long-term Treasuries would gain far more if yields went down than they would lose if yields went up by the same magnitude.
Additionally, some of the supply/demand concerns may be overblown, as pensions and insurers are keen to lock in generationally high yields to offset their liabilities, while the carry offered by U.S. bonds over other developed market peers should continue to attract foreign buyers.
Thankfully, this need not be a binary decision. Portfolio duration does not have to be 100% short or long, but can reside anywhere along the spectrum. Despite a challenging macro environment for longer-term bonds, their favourable risk/reward asymmetry and renewed ability to offset equity risk cannot be ignored. We remain short duration for the time being, but will be looking to incrementally lengthen the maturity profile in the coming months and quarters.
As near-term recession concerns ebb, money that was sitting on the sidelines should work its way back into risk asset markets. Professional investor surveys show this trend is well underway, with cash positions declining from near-historically high levels. We expect continued flow into global stock and bond markets and have reduced cash and equivalents exposure to neutral in client portfolios.
Emerging market central banks, particularly in Latin America, have won some tough-earned credibility by not dismissing burgeoning inflationary pressure as transitory and proactively hiking interest rates well before their developed market peers. Now, with inflationary pressure decisively rolling over in most major EM nations, emerging market bond yields have significant room to decline as central banks embark upon rate cutting cycles. Emerging market bonds remain overweight this quarter.
Investors have a lot to digest these days, as tightening monetary policy and rising energy costs are offset by resilient corporate profits and fiscal expansion. On balance, the outlook for equities remains favourable as fiscal stimulus has a more potent “real economy” impact and corporations opportunistically extended liabilities when interest rates were low. We remain overweight equity exposure in client portfolios.
The transition away from fossil fuel-derived energy sources will intensify the reliance on “bridge” fuels such as natural gas and nuclear (uranium), as renewable sources including solar and wind will take time to scale up. Natural gas looks particularly attractive at present as Europe remains vulnerable to a harsh winter, global supply/demand conditions are tight, and the Henry Hub price appears to be bottoming. A position in natural gas equities has been initiated in balanced and growth-oriented strategies this quarter.
David Kletz, CFA, is Vice President and Lead Portfolio Manager at Forstrong Global Asset Management. This article first appeared in Forstrong’s Insights Blog. Used with permission. You can reach David by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at dkletz@forstrong.com.
Notes and Disclaimers
© 2023 by Forstrong Global Asset Management. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.
The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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