Fixed Income Insights: To Extend or Not Extend That is the Question? A Note on Duration in the US bond markets

Shakespeare’s famous quote from Hamlet “to be or not to be -that is the question” is a dilemma that investors are facing today, when duration positioning is concerned.

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We opine that a neutral positioning (Modified Duration of 5-7) on duration needs to be maintained with a skew towards the lower end of the range. Investors with duration lower than that should take the recent spike in yields as an opportunity to increase duration to around 5, albeit in a staggered manner. This is largely since the pace and extent of rate cuts is susceptible to recalibration given a still strong economic backdrop and possible reflationary risks post US elections.

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What changed in the month of October 2024?

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The spike in yields reflects a combination of stronger than consensus economic data prints, possibility of fiscal profligacy and tariff related inflationary pressures, especially in the event of a Republican win and oil price risks from the ongoing Middle East conflict. We should note that while potential tariffs receive all the attention, fiscal prudence is unlikely under either outcome in the US elections. 

What is the way forward?

The theoretical concept of the Neutral rate (R*) becomes the most important metric to watch in the Fed communication going forward. This is the rate that neither stimulates nor restricts the economy or in other words a state of Nirvana.

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The median forecasts for the long-term Fed funds rate in the September SEP (Summary of Economic Projections) rose to 2.9% (current Fed’s fund rate is 4.75%-5%) and has been on the rise in the last three SEPs. This is the neutral rate that is the collective estimate of the US Fed officials. But at that rate we had a range of 2.5% to 3.8% as well, signifying the dispersion in estimates.

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Whatever the case is, economic data releases in the coming months will change the Fed’s estimates and that will also be our approach in managing duration in clients’ portfolios.

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Continuation of strong economic data releases and a Trump presidency will be triggers to reduce duration below 5 while softer than expected releases and continuation of a Democrat government will set us on a path to extend duration beyond 7 (current positioning is 5).

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