The first half of 2022 has been marked by heightened turmoil across all global markets, but the bond markets in particular have experienced a rude “wake-up” call delivered by changing US Federal Reserve (Fed) policy and rhetoric, exacerbated by the geopolitical risks associated with the Ukraine/Russia conflict. The upshot: After a long hiatus, volatility has roared back into the interest-rate and credit markets this year.
Accordingly, we believe now may be an opportune time to allocate marginal capital to shoring up your fixed income “flank” – the part of your portfolio that is intended to defend against elevated or potentially accelerating volatility, as well as against the threat of economic recession. (To be clear, we are not yet forecasting a recession in the months ahead, but we do see some concerning signs that asset markets may face continued challenges, at least in the immediate term.)
With the fixed income landscape having shifted in this manner, perhaps your portfolio should as well.
Four reasons to think defensively in fixed income
1) Increased market volatility and macro uncertainty. As shown in Figure 1, looking at the “normalized” volatility of the 1-year/10-year portion of the US Treasury yield curve (i.e., a gauge of where the 10-year Treasury yield is likely to be a year from now), market volatility has increased meaningfully over the past several months. In fact, recent volatility levels have surpassed those reached during the throes of the COVID-19 pandemic. In general, the higher this metric, the greater the uncertainty around where the forward 10-year yield will be 12 months from today. Basically, this reflects a lack of market consensus these days as to the future trajectories of both inflation and interest rates.