State Street SPDR ETFs: Positioning for easier policy and politics

25 juli 2024

Central banks are starting to deliver cuts. This indicates now may be a good time to add some duration to portfolios to potentially enhance returns. However, the data continues to fall into place only gradually and politically induced volatility points to remaining cautious.

The market has, at times, clearly looked overly aggressively priced for Federal Reserve (Fed) cuts in light of the persistent strength of the US economy and stickiness of inflation. In addition, the inverted term structure of rates means that, as an investor, you are not compensated for extending out along the curve. As a result, we have preferred to focus on short-maturity strategies. On the data front, there are finally hints that the economic winds are changing. The Bloomberg US Economic Sentiment Index has been in negative territory for all but one of the past 13 weeks and is close to its February 2019 lows and expectations are for inflation to ease further.

Cautiously Moving Towards Longer Duration

Figure 1 illustrates the value of being longer duration as the rate cutting cycle gets underway, with the 7-10Y maturity bucket outperforming shorter exposures and even the all-maturities index (which also has a slightly shorter duration). Being long duration produces higher returns if a cut is delivered, but can be costly if it does not materialise.

Pushing the first rate cut in the cycle further into the future has been a common theme this year. Even as we enter the second half of the year, the market does not have the confidence to price two full 25 basis point rate cuts from the Federal Reserve. This underlines both a lack of conviction that the economic data falls into line and complications around the US election.

The significantly lower returns for the short-maturity bucket (seen in Figure 1) suggest it is worth moving closer to neutral market duration. The 3-7Y part of the curve looks well positioned; its performance was in line with the all-maturity exposure in the run-up to the first Fed easing in 2019. However, for 2024 year to date, it has proved more defensive, with the most extreme losses in April being -2.5% against -3.4% for the all-maturities index.

The ECB Gets the Ball Rolling

For Europe, rate cuts are already in play. The ECB took their deposit rate down from 4.0% to 3.75% at the start of June. As suggested by Figure 2, which shows the mini easing cycle undertaken by the ECB in 2011, it makes sense to extend duration as the cuts get underway.

For several quarters we have been advocating neutral duration positions but through a barbell structure: short-dated investment-grade credit for yield coupled with long-maturity government exposure to add duration and convexity. This has worked well, returning 24 bps more than the all-maturity government bond index over the quarter.

However, returns were still negative, as market pricing had been contaminated both by volatility in US markets and political issues in Europe. Only investors in the short part of the curve would have seen positive returns. Therefore, it may make sense to focus on the shorter part of the curve. As can be seen in Figure 2, the returns from the 3-5Y part of the curve kept pace with the all-maturities index during the early part of the 2011 easing cycle. It has also proved more defensive during the first half of 2024.

Jason Simpson, Fixed Income ETF Analyst at State Street SPDR ETFs:

'With the UK election now out of the way, the political backdrop looks more settled. Growth has rebounded after a weak end to 2023 and CPI has returned to its 2% target. The Bank of England (BoE) has the cover it needs to cut rates and two of the nine MPC members already voted to ease policy at the June meeting.

That said, it is unlikely to adopt an aggressive stance given fears that CPI may creep higher into the end of the year. There is also uncertainty over growth. The new Labour government has plenty of ambition to kick-start the economy, meaning the BoE may be wary of expansionary fiscal policies.

An increase in gilt supply may steepen the curve. While there are signs that the curve out to 10 years is reverting back to a steepness that is more consistent with the levels seen prior to the financial crisis, there is still some term premium rebuild that needs to occur to get there. In our opinion, given these uncertainties, it would make more sense to focus on the front end of the curve where the higher yield and shorter duration provides more protection.'