Bond Market Observations: Epitaph For A Trade

"Or is it that all experience is partial and incomplete, that what seems a short, straight line today is merely part of a rational circle?"

—Eric Ambler, Epitaph for a Spy, p.1.

To cut to the chase, after looking into all the moving parts of our economic outlook and assessment of fixed-income valuations (and revising more than a few) this month, we retain our core advice to prudent investors. Maintain a relatively lean risk budget and emphasize more liquid risk factors. True, the volatility of financial markets is phenomenally low and there have been some blowout returns posted in a few asset classes this year. We have benefitted from this in our high-yield and emerging-market holdings, among other places. If the past were prologue, it might seem time to lean into risk.

This is not the time. Capital gains this year have flattened the tradeoff between expected return and risk to an unattractive degree. The duration of the aggregate fixed-income portfolio has risen to the point that it does not take much of an adverse event to swamp skimpy carry. In six months’ time, if the central tendency of our economic outlook eventuates, US inflation will have revived, investors will better appreciate that the Federal Reserve intends to hew to its plan to renormalize monetary policy, and worries will emerge about the signal regarding future economic activity sent by a flattening yield curve.

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