Fixed income

A quick analysis of topical fixed income thoughts.

The Fed’s recent hawkishness is quite visible below, Trade Weighted Dollar (TWD) up, risky assets down, spreads widening, short dated yields up, term spreads down.

10s are a function of the below variables, expected inflation, term premia, and the average expected future short rate.

All things considered term premia have been very well behaved.

I suppose as a “everything else” premia, it reflects the markets belief that in the long run, the Fed has a firm handle on policy and its outcomes (low and stable inflation), relatedly, that is what’s confirmed by BE’s.

How much it reflects general uncertainty, or preferences for insurance, is perhaps implied by the unemployment rate, to which it correlates (assuming independently measured).

If UR spikes up (recession) TP likely up, but yields in total almost certainly down, as the average of expected future rates comes down by more.

We can stick these components into a model, regressed against the output gap. If we do so, we find the current real rate well explained by the output gap (overheated economy).

If the above is right, than 2.5% real + 2% inflation + 0.5% term premia get you to ~5% for the 10 year. But I guess no-one thinks of a +ve OG “for the long run” (the whole thing, i.e. the economy breaks down, if the OG doesn’t close!), in which case it’s 0.71% (the model intercept when there’s no OG) + 2% + 0.5%.

So 3.2% might be where 10s wind up. It’s not crazy to own ’em.

Now, that might all seem complicated, so we can try some simpler stuff.

It is interesting to note that every time the FFR hit the neutral estimate, the Fed had to reverse course shortly afterwards. None of those prior episodes produced inflation, mind you, so some overshoot now has to be warranted.

I do know, however, that the homebuilders will not thrive when the mortgage rate looks like the below, and in general, being long cyclicals, and materially OW risk, doesn’t seem especially sensible.

And, turning locally, you can throw another 25bps on the mortgage rate barbie, where rather than shrimp it is homeowners being bbq’d.

Again, in our view, a reason not to be materially long risk, in the local market, or at least, defensively positioned within the risk you do take.

We don’t have any exposure to EM credit, however we have pared back our EM equity exposure, really based on the hawkish Fed and the well-known effects on EM everything, + energy mix issues, even as the acute phase of the crisis passes. Not a lot of spread there, below, for what is a risk part of the world.

Our EM trade made a little money, added post the China tech/state champion/golden dragon meltdown of last year. India down, China up, net impact on the index still positive, but not as huge as hoped. Reopening as +ve catalyst fade, really.

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