Is the market providing investors with a second opportunity to extend duration in their portfolios?

Many homeowners who have rolled off fixed rate mortgages into somewhat painful floating rate alternatives, may have taken great comfort from last week's Bank of England (BoE) meeting.

Although the Monetary Policy Committee (MPC) voted for no change to the base rate, the voting shifted from 1-8 to 2-7 in favour of cutting. Governor Andrew Baily stated in his press conference that they will 'likely need to cut bank rates over the coming quarters' and 'possibly more so than currently priced into market rates'. The market is currently pricing in a rate cut in August and another near the end of the year. Bailey later stated that a 'change in bank rate in June is neither ruled out nor fait accompli'.  

Some MPs have castigated the BoE for what they call 'miserable incompetence' over its failure to reduce inflation more quickly. However, the accompanying chart contrasts the Bank of England's (BoE) six-month forecasted inflation rates with the actual inflation rates (highlighted in light blue). This visualisation suggests that while the BoE may have been slow to respond during the initial stages of the COVID recovery, their predictive accuracy and control over inflation have noticeably improved in more recent periods.

Source: Bank of England: MPR short-term inflation forecasts, 13/05/24

With over 40 Conservative MPs urging Chancellor Jeremy Hunt to review the Bank's mandate and independence, the situation echoes concerns from 27 years ago when Gordon Brown granted the BoE autonomy from political interference—a move widely regarded as beneficial. However, if political pressures begin to sway interest rate policies, particularly for electoral gains, perhaps it complicates predictions for future rate movements.

So, what does all this mean for investors? Although market volatility, as measured by the VIX, has been trending downward, the MOVE index, which tracks volatility in U.S. interest rates, remains elevated. This persistent uncertainty in the rates market has made many investors hesitant to fully extend the duration in their portfolios. Meanwhile, underlying clients appear content earning a relatively stable 4-5% from short dated bonds. But, how much protection can short dated bonds offers to a wider multi asset portfolio? Considering that 10-year rates are hovering around 4%, could this signal a resurgence of the traditional 60/40 portfolio?

Source: Factset: MOVE Index, 18/06/14 - 13/05/24

The past six months have been tumultuous, with yields falling in Q4, to only spike again in Q1. Perhaps the market is providing investors with a second opportunity to extend duration in their portfolios.

Many investors, having faced significant capital losses over the past few years, might be overlooking the fact that bonds can provide not only regular interest payments, or coupons, but also potential capital appreciation. One notable insight from the MPC minutes is that they project inflation will drop below target by 2026 (1.9%, revised down from 2.2% at last meeting).  Assuming they are right and want to maintain around 100bps real yield, there’s a plausible scenario where the 10 year falls to 3% or lower in the event of a recession. Meaning an allocation to 10yr UK government bonds with a duration around 8 years could offer 8% capital upside plus 4.1% coupon. 

So, how should the Atlantic House Dynamic Duration Fund perform in this environment? The fund is currently neutral on US and UK rates, meaning it has around an 8 year rates duration in both regions and around 4 year duration in inflation swaps.

Andrew Bailey's comment; “We have no preconceptions about how fast or how far we might cut bank rates, instead we will continually look carefully at evidence” resonated with us in regards to the systematic strategy we employ in the Dynamic Duration Fund. We do not rely on guesswork, instead, we utilise three specific signals to guide our predictions of future interest rate movements.

This systematic process ensures that any decision making, much like the MPC, is rooted in solid economic indicators rather than conjecture.  Although the fund is currently neutral bonds, it will systematically pivot further into bonds if inflation continues to fall. If the Governor is wrong and inflation comes back to bite, the inflation swaps in the fund can offer some protection. We believe the fund is a good option for those investors looking to extend their rates duration, but have a buffer if inflation proves stickier than the market predicts.

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