Time to think about the downside
Never be short duration for too long, be wary of risk assets when they are too expensive, always assume the England football team loses. Those three assumptions have served us pretty well over the years and into 2021, but before we get to bond land, congratulations to Italy on their hard-fought victory.
Duration extends its Q2 run
There is a big rally going on in government bonds. It is now more than three months since bond yields peaked at 1.74% in US Treasuries and, since then, we have seen a 50 basis point rally, which has accelerated recently (as of mid-July). There is much debate about what is driving this move: some argue that it is very technical driven with negative or short duration investors being squeezed and CTA accounts (derivative and momentum) potentially driving the market lower in yield as they close their short positions.
From a fundamental perspective, some argue that it's the end of the reflation trade and the market is now pricing in a less perfect growth and inflation outlook. From a valuation perspective, it's difficult to argue that investors are driving markets lower in yield because they see the market as cheap but, with the benefit of hindsight, clearly 1.75% was very cheap!
As ever, if you mix all of those views together – a combination of what we would call Macro, Valuation, Sentiment and Technical factors – we conclude there are more buyers than sellers and should move with the markets. We have been adding duration over recent months and are now benefiting from the underlying move.
Chart 1: Ten-year Treasury yields have fallen back over the second quarter
Time for caution on credit?
Credit spreads have benefitted year-to-date from strong demand, improving fundamentals and lower default expectations. On most metrics, credit yields and spreads are looking rich but, much like government bond yields, it is entirely possible that yields and spreads can stay expensive or become even more expensive, given the various supporting factors.
That said, credit is certainly back to pre-Covid valuations and is more expensive in places than post the Global Financial Crisis. In certain parts of the market, it is more expensive than ever.
We have stopped adding to credit risk and in some markets have reduced exposure, moved to short duration, and preferred investment grade over high yield. We are looking to hedge other parts through the usual use of duration or credit default swaps. We suspect that volatility will be a buying opportunity for many investors looking for some cheaper entry points into credit, but maybe over the quiet summer weeks and months the market gives back some of the 2021 gains.
And as for the football?
Despite the euphoria and subsequent disappointment on Sunday, England fans are still proud of the team – after all, a final appearance does not come round very often. You might not have picked England or duration to perform three months ago, but it is also worth listening to the contrarian case!
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