Bond market: 'There was no cushion' in yields to offset rising rates, strategist says

WisdomTree Global CIO Jeremy Schwartz and Northwestern Mutual Wealth Management Senior Portfolio Strategist Matt Stucky to discuss the bond market and how it's reacted to rising interest rates and inflation.

Video transcript

JARED BLIKRE: As we head into the closing bell. And here we go.

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SEANA SMITH: Another day of declines as we wrap up the trading day. All three of the major averages ending in the red. The Dow off 347 points as we shake out the final trades of the day. S&P off just around 1%. NASDAQ off about 7/10 of a percent. The sector action, energy the only sector closing the day in positive territory. The worst performers on the flip side, real estate and utilities, both of those sectors off just over 3%.

All right, let's make sense of the action that we saw today. And for that, we want to bring in Matt Stucky, Northwestern Mutual Wealth Management senior portfolio and strategist. And we have Jeremy Schwartz, WisdomTree Global chief investment officer. Great to see both of you. Matt, let me start with you. Just in terms of the equity moves that we're seeing today, once again, another day of declines, coming off a very strong start to the week. What do you think of the action that we've seen over the past four days?

MATT STUCKY: Well, good afternoon. Thanks for having me on the show. I think this is just really a continuation of what we've been dealing with all year in terms of an elevated volatility profile for the market. The market is hanging on to every kind of whiff of inflation report that's out there.

Good reports are being met with relief rallies in the market, while hot reports on inflation are just furthering the pain and increasing volatility even further. And we have a jobs report tomorrow morning, which we'll wait and see how it looks. But it's just going to be another data point that markets are going to probably trade off of significantly, as we look to see how the employment market is functioning here.

DAVE BRIGGS: And Jeremy, do we learn more from the strong start to the week in the quarter or the last two days in the pullback?

JEREMY SCHWARTZ: You know, it's-- we've all been bond traders, as Matt was talking about, where it's all pivoting on rates and the Fed. And sort of, you had rates fall. It started with the Bank of England stepping in to support the markets and the bond markets. Now, it was already a temporary measure. So the question is, do they think things can go beyond that?

I do think sentiment was very washed out. So there was an element of just sentiment being so negative that there was some measure saying [INAUDIBLE] was at a zero, and so can you go up from there? So I do think there was some relief rally from that relief from bond pressure coming off. We do think the Fed should pivot in their November meeting. We think they should go more like 50, instead of 75.

But we'll see as the next month comes if that is true. That would be another further catalyst for the beginning part of this week than the last few days. But it certainly all trading off of what's happening in the bond market, is the key driver here.

SEANA SMITH: And Jeremy, how are you-- I guess, how are you managing some of the risk there in the bond market? Because we certainly have seen a ton of action. 10-year yield up once again today, up another 6 basis points to 3.81. How are you adjusting your portfolio as a result?

JEREMY SCHWARTZ: Yeah, we manage model portfolios for and help give some guidance to clients on how do we think about that. We've been very underweight duration for a while. And coming into the year, yields were so low, there was just no cushion to offset any rise in rates. This is the first quarter where we've sort of upped our duration.

So we had two strategies. One's a floating rate Treasury [INAUDIBLE]. It's been the best play for a rising Fed. We've also had a yield enhanced core, AGGY, which is just a little bit longer duration than the ag. We sort of moved some from the floating rate treasuries to the yield enhanced core at our recent rebounds across a lot of our models.

We're still underweight duration. We're saying we're not ready to fully join the duration party. We're still short duration versus our benchmarks. But we sort of cut the gap in half because we do now think yields are very different. You've got a few hundred basis points increase in real yields. There's really now yield back in fixed income. In the high yield market, you can get 8% to 9% yields. So it's just a very different story than when you started the year. And so we did cut that duration gap in half in a lot of our model portfolios.

DAVE BRIGGS: And Matt, you said you still expect a couple of elevated CPI reports based on the back of housing. Why, and what are you seeing overall in the housing sector that gives you a sense of where the entire economy might be headed?

MATT STUCKY: Yeah, this is a really good point-- really critical point to make here about housing, is that housing flows into CPI with about a year and a half lag. So what you're seeing in CPI right now in the services component, 1/3 of which is housing, is what we saw in the housing market in 2021. And we all remember what housing looked like last year where annualized gains were 20% or higher.

But it's a very completely different story as we look at what the housing market looks like this year. From where we started this year up until this week, mortgage purchase demand is off 37%. And the month on month gains in the housing market are history. We've gone from month on month gains of 1 and 1/2% to 2% to negative territory over the summer.

And considering where affordability is and where mortgage rates have been trending this quarter, it's likely that we're going to see further declines. And so that's going to take some time to filter into overall headline inflation and core inflation.

But the question is, is whether policymakers at the Federal Reserve and other central banks around the world will look to more of a forward-looking indication of where inflation is going, not the stale inflation that we're likely to see, which is going to be elevated for the next couple of quarters because, again, housing moves into the numbers with about a year to year and a half lag.

SEANA SMITH: And Matt, given all the uncertainty that you were just talking about in the market, some of the challenges that investors are facing right now, what do you like?

MATT STUCKY: That's a good question. You know, I think diversification is your best friend in volatile markets. And we agree with Jeremy that a lot of value has been restored into the bond market. And so while it's been a painful reprice this year, invest in great corporates around the five-year mark, are trading between 5% and 5 and 1/2%. That provides you some cushion against traditional equities.

Within equities, the positioning we've had for the last couple of years is to be tilting our portfolios towards cheaper parts of the market. And we think we that's still an attractive place to be invested. Value spreads continue to be historically wide. And so if you think that a recession is coming in 2023 and we-- our base case is that we do have some sort of a mild recession, there's a lot of cushion already built into the price.

A sector neutral kind of value implementation in the large cap space trades less than 9 times forward looking earnings. And so even if estimates get cut significantly for that basket of equities that I just mentioned, you still have a lot of cushion because it's only, like I said, nine times earnings.