Federal Reserve's dovish state of mind puts quality assets at risk

Federal Reserve's dovish state of mind puts quality assets at risk

Bonds
Althea Spinozzi

Head of Fixed Income Strategy

Summary:  By maintaining monetary policies easy but letting long-term yields free to move, the Federal Reserve gives support to lower quality credits while putting quality at risk. We are heading towards an unprecedented duration event that will weight on high duration assets, which in the bond market are concentrated within the investment-grade corporate space. The US investment grade (IG) corporate bond sector is heading to the worst quarter since 1981, with the utilities and communications sectors being more exposed to rising interest rates than others. The technology sector, which saw stellar valuations in the stock market last year, is characterized by a duration of eight and a half years, which matches the US IG average.


The market doesn't care about the Federal Reserve's dovish state of mind. The Fed said it itself: the economic outlook is improving substantially with inflation destined to rise together with the country's GDP, while the labour market gets stronger. Nevertheless, the central bank decided to stand still and continue with its accommodative monetary policy. This decision leaves the market with the only option to take the situation into its own hands and dumping Treasuries that will inevitably lose value.

The steeping of the US yield curve resumed this morning with the curve's belly and the benchmark 10-year yields rising faster than long-term US Treasuries. The big issue is that if economic forecasts and inflation expectations continue to rise, rates will not stabilize until the Federal Reserve decides to intervene and engage in the infamous yield curve control (YCC). In our view, YCC will be unavoidable because, although the market can function with higher rates now, the higher they go, the more the pain that will be inflicted on those assets with historically high durations.

The market is talking about 10-year yields hitting 2%; however, if the Federal Reserve continues to keep watching, they might rise much further. The Fed has been able to maintain easy financial conditions by keeping real rates negative. However, they will not stay negative forever. In normal circumstances, nominal yields should price over the breakeven rate. It means that if inflation expectations continue to rise, we inevitably will see 10-year yields rising above 2.3%.

Source: Bloomberg and Saxo Group.

A broad cross-asset selloff might spark from high-grade credits  rather than junk

Yesterday’s FOMC meeting and today’s selloff in sovereigns reinforce our belief that we are witnessing a historical duration event. The investment-grade corporate bond market will fall faster than junk within this context because of its sensibility to higher duration. Indeed, while the average duration within junk is around three and a half years, the investment-grade bond space carries a duration of more than 8 years. Duration within quality credits has recently increased dramatically: in the past two years, duration has increased by one year and a half. To put things into context: it took four years after the global financial crisis for the duration to increase by as much.

Source: Bloomberg and Saxo Group.

If we put Treasuries into the equation, we would see that in 2013 amid the Taper Tantrum, 10-year yields rose by 130 basis points; however, investment-grade corporate bonds fell only by 2%. This year Investment-grade corporate bonds have fallen already by 3.36%, the most in forty years, with 10-year yields rising only by nearly 85bps showing that duration is a bigger threat than credit quality. Indeed, by maintaining monetary policies easy, the Federal Reserve gives support to lower quality credits on one hand. On the other, by letting long-term yields move freely while inflation expectations are rising, the central bank puts quality at risk. And who sits on quality? Everybody, more in particular real money with long-term strategies such as insurances and pension funds. And again, it is deja-vu: we might be headed towards another Global Financial Crisis?

Source: Bloomberg and Saxo Group.

As the yield curve continues to steepen will be essential to limit interest rate sensitivity. It will be interesting to know that the sectors that carry the highest duration are the communication and utility sectors whose duration is well above 10 years. The technology sector is within the US IG average, with around eight years and a half in duration. For those looking for quality while reducing duration sensibly, high-grade financials provide 6 years duration, almost half than that offered by the communications and utility sectors.

Quarterly Outlook

01 /

  • Equity outlook: The high cost of global fragmentation for US portfolios

    Quarterly Outlook

    Equity outlook: The high cost of global fragmentation for US portfolios

    Charu Chanana

    Chief Investment Strategist

  • Commodity Outlook: Commodities rally despite global uncertainty

    Quarterly Outlook

    Commodity Outlook: Commodities rally despite global uncertainty

    Ole Hansen

    Head of Commodity Strategy

  • Upending the global order at blinding speed

    Quarterly Outlook

    Upending the global order at blinding speed

    John J. Hardy

    Global Head of Macro Strategy

    We are witnessing a once-in-a-lifetime shredding of the global order. As the new order takes shape, ...
  • Asset allocation outlook: From Magnificent 7 to Magnificent 2,645—diversification matters, now more than ever

    Quarterly Outlook

    Asset allocation outlook: From Magnificent 7 to Magnificent 2,645—diversification matters, now more than ever

    Jacob Falkencrone

    Global Head of Investment Strategy

  • Macro outlook: Trump 2.0: Can the US have its cake and eat it, too?

    Quarterly Outlook

    Macro outlook: Trump 2.0: Can the US have its cake and eat it, too?

    John J. Hardy

    Global Head of Macro Strategy

  • Equity Outlook: The ride just got rougher

    Quarterly Outlook

    Equity Outlook: The ride just got rougher

    Charu Chanana

    Chief Investment Strategist

  • China Outlook: The choice between retaliation or de-escalation

    Quarterly Outlook

    China Outlook: The choice between retaliation or de-escalation

    Charu Chanana

    Chief Investment Strategist

  • Commodity Outlook: A bumpy road ahead calls for diversification

    Quarterly Outlook

    Commodity Outlook: A bumpy road ahead calls for diversification

    Ole Hansen

    Head of Commodity Strategy

  • FX outlook: Tariffs drive USD strength, until...?

    Quarterly Outlook

    FX outlook: Tariffs drive USD strength, until...?

    John J. Hardy

    Global Head of Macro Strategy

  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

None of the information provided on this website constitutes an offer, solicitation, or endorsement to buy or sell any financial instrument, nor is it financial, investment, or trading advice. Saxo Capital Markets UK Ltd. (Saxo) and the Saxo Bank Group provides execution-only services, with all trades and investments based on self-directed decisions. Analysis, research, and educational content is for informational purposes only and should not be considered advice nor a recommendation. Access and use of this website is subject to: (i) the Terms of Use; (ii) the full Disclaimer; (iii) the Risk Warning; and (iv) any other notice or terms applying to Saxo’s news and research.

Saxo’s content may reflect the personal views of the author, which are subject to change without notice. Mentions of specific financial products are for illustrative purposes only and may serve to clarify financial literacy topics. Content classified as investment research is marketing material and does not meet legal requirements for independent research.

Before making any investment decisions, you should assess your own financial situation, needs, and objectives, and consider seeking independent professional advice. Saxo does not guarantee the accuracy or completeness of any information provided and assumes no liability for any errors, omissions, losses, or damages resulting from the use of this information.

Please refer to our full disclaimer for more details.

Saxo
40 Bank Street, 26th floor
E14 5DA
London
United Kingdom

Contact Saxo

Select region

United Kingdom
United Kingdom

Trade Responsibly
All trading carries risk. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more
Additional Key Information Documents are available in our trading platform.

Saxo is a registered Trading Name of Saxo Capital Markets UK Ltd (‘Saxo’). Saxo is authorised and regulated by the Financial Conduct Authority, Firm Reference Number 551422. Registered address: 26th Floor, 40 Bank Street, Canary Wharf, London E14 5DA. Company number 7413871. Registered in England & Wales.

This website, including the information and materials contained in it, are not directed at, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in the United States, Belgium or any other jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation.

It is important that you understand that with investments, your capital is at risk. Past performance is not a guide to future performance. It is your responsibility to ensure that you make an informed decision about whether or not to invest with us. If you are still unsure if investing is right for you, please seek independent advice. Saxo assumes no liability for any loss sustained from trading in accordance with a recommendation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.

©   since 1992