Fund selectors have tapered their exposure to bond ETFs in recent weeks in the face of a resilient US economy and elevated yields, however, with central banks signalling rate cuts, this is the time to start adding significant duration risk to portfolios.
The unexpected strength of the US economy has created an asset allocation headache for fund selectors, with many positioning portfolios for a recession and subsequent sharp fall in yields since the start of 2023.
Highlighting this, fixed income ETFs in Europe saw a record $65bn inflows last year, according to data from ETFbook, as investors locked in elevated yields following the sharp rise in inflation in 2022.
However, the narrative has waned this year. After strong inflows of $8.4bn in January, demand slowed to $3.4bn and $1.3bn in February and March, respectively.
In particular, strategies such as the Amundi US Curve Steepening 2-10Y UCITS ETF (STPU) and the Invesco US Treasury 7-10 Year UCITS ETF (TRDX) have seen outflows of $561m and $333m in Q1, respectively, a sign investors are increasingly concerned about the inflation outlook and the possibility of US rate cuts.
Traders are now pricing in a 55.8% chance the Federal Reserve will reduce rates at its June meeting and three cuts overall in 2024. This is some distance away from the seven cuts priced at the start of the year which explains the negative sentiment towards fixed income.
However, with the majority of US Treasuries still yielding above 4.5%, investors have another opportunity to add duration risk to portfolios.
“As we are approaching the first rate cut, with the Fed and the European Central Bank (ECB) expected to move in June and the Bank of England soon after, bond prices should rise further,” Willem Sels, global CIO at HSBC Global Private Banking and Wealth, said.
“Locking in still attractive yields before it is too late is the right thing to do. This can be achieved by putting cash to work in bonds and extending bond duration.”
While US inflation has remained stubborn this year, easing price pressures from areas such as the services sector has led Fed chair Jerome Powell to signal three cuts in 2024.
Investors should consider the mantra ‘do not fight the Fed’ and seriously consider adding further duration risk to portfolios.
“No matter where we sit in the interest rate cycle, bonds play a key role in any portfolio because they provide diversification and predictable income streams,” Sels added. “We overweight longer duration (7-10 years) developed market government bonds including US Treasuries.”
