Hello and welcome to The Download. I'm your host, Dave Richardson. And because we want to find out about fixed income post-election, we are joined by our good friend Andrzej Skiba, head of US Fixed Income at Blue Bay Asset Management in Connecticut. So you're down right in the heart of the action post-election. Is there anything going on out in the streets behind you? It looks like a nice day.

It's a beautiful day and things are much calmer than many could have expected. So yes, the storm seems to be over now that everyone's got clarity about the outcome of the election. But it's great to catch up with you, Dave, and speak about how we look at the world now that at least some answers we got.

So, Andrzej, on your previous couple of appearances, we were speculating what might happen with either Harris or Trump winning. And I'm interested now that we've got certainty around the result. We still have, I guess, a lot of uncertainty around the actual policies that will be put in place, whether he follows through on all of the things that he talked about during the campaign, or it was a lot of bluster, and then he pulls back from that. Some of the trade was in place in advance of the actual election, and then it accelerated after the final decision. So were you happy with the way you were able to position the portfolios coming into the election? Now that you have that result, what are you looking at now?

Yes, things worked out well from our portfolio perspective because what we wanted to implement ahead of the election were two key views. The first one, we want to be lighter in terms of our US duration exposure, anticipating that, in the event of a Trump win, you would see higher treasury yields. That was one key focus, and we reduced our duration exposure across a variety of mandates that we managed in anticipation of the election day. The other one was to be bullish on spread risk. The reason being we were bullish on credit is that we felt that in the event of a Trump win — and that was our base case scenario for quite some time now — credit markets and fixed income markets would first take the cue from the equity markets. Looking from that lens, we felt that lower taxes, less regulation, more M&A are all music to equity investors' ears. In the initial stages after the election, assuming Trump was successful, we felt that that will fuel positive sentiments across spread products as well. That is why we felt being light in terms of duration exposure, but bullish from a credit spread exposure was the right combination, and so far it has worked pretty well.

Excellent. A month ago was the last time we connected. So it did become clearer in your eyes, and you did have that view that things were leaning towards Trump and the markets were giving that signal. So that's exactly the way you positioned yourself.

We think so. To us, the key in allowing us to have a firmer view that Trump is the likely outcome in the weeks coming into the election was how neck and neck they were running in a variety of battleground states. Knowing that in the past, in the previous elections, Trump's actual vote was significantly underestimated in polling, and while that gap has narrowed, it was still quite substantially close to 5%, even in 2020, we felt that that gap would have to be completely eradicated it for Harris to have a shot when they're running neck and neck. But in all likelihood, very close battleground polls suggest that Trump should be in a better position to win, given that underrepresentation that we've seen for a number of elections. That's really what gave us confidence. We've seen no evidence of Harris numbers breaking out higher in advance of the election in those battleground states. So that is why we've positioned for a Trump outcome across our strategies.

Very interesting. Looking at the numbers and looking at the history, you were able to make a call. That's part of being a portfolio manager, making those calls as a team of portfolio managers. And that's good that you had it right in terms of the positioning of the portfolios. So now we have the election behind us. We had already seen through October — if I look at the 10-year treasury yield in the US — that it was drifting higher. And then during the election, it just all of a sudden spiked about 14, 15, maybe as much as 18 basis points at some time through the evening. It continued a little bit yesterday, but now it's settled back today. Stock market, obviously, a massive rally. And you talked about the reasons why the stock market is positive on this outcome. So where do you go from here? Is it wait and see or are there things that you want to do to position your fixed income portfolio, given what you think will play out over the next 2-3 months, and then ultimately when Trump's inaugurated?

Look, we're trying to implement a number of things across our strategy. The first one is booking profits in credit markets. As I mentioned, we had spreads rallying aggressively tighter, held by a positive equity sentiment. But we're now trading at levels that in many markets are close to multi-earned types. We feel that the opportunity cost from booking profits and reducing exposure until we have more clarity ahead is quite low right now. It makes a lot of sense to us to reduce exposure to credit, especially longer duration bonds in credit at this juncture. The other thing that strikes us is one of the reasons why we've seen a spike in yields in the aftermath of the election, even though, as you rightly pointed out, we've already priced in some of that Trump outcome with a move higher in yields, is that the market did not expect the outcome to include a clean sweep for Republicans. So the market still assumed that House could go to Democrats and Senate and White House to the Republican side. Having now a clean Republican sweep allows Trump's team to have pretty much a blank check in terms of implementation of policy, and the market has interpreted that as increasing the likelihood of more elevated deficits over the quarters to come. So that is the reason why we've seen underperformance of 30-year bonds in the aftermath of the election and steepening of the 2-30 treasury curve. And we think that's valid. We think Trump will tolerate more elevated deficits. We see still some downside for 30-year bonds, maybe even hitting 5% over the coming months. We feel much more comfortable at the front-end of the curve where we feel a lot of an adjustment has already happened. Bias against longer duration treasuries and finding a bit more safety after recent moves at the front end of the curve is the second view that we're implementing. The last one is to do with when we're going to get clarity on the policy front. Because to us, if a trade war were to ensue, and if, as Trump mentioned repeatedly in his speeches, you could see 10% tariffs on a majority of trade partners and a majority of goods, that could be very inflationary. On our modeling work, we see up to 1% increase in headline inflation in that scenario. 1% doesn't sound like a lot, but 1% can make all the difference between Fed being able to cut rates and not. If indeed this administration will pursue an aggressive trade agenda from early on, and we do get that clarity that indeed this is what's transpiring, we feel that that, again, will be an environment where you want to hide in shorter duration assets where you want to have less exposure to longer duration treasury assets or credit until the dust settles. And look, eventually, once that policy clarity is found, I have no doubt whatsoever that investors will come back into the space and investors will be happy to put money to work in high fives or even sixes in terms of yields within investment rates. But for the time being, we just want to reflect on the fact there's been so much money put to work in US fixed income in anticipation of aggressive rate cuts ahead. So if that narrative were to change, better be safe, stay in short duration in assets that are less vulnerable to these shifts, and then when we have the clarity, decide whether it's time to reengage. But caution for the time being is advised.

Wow, 5%. That hit me hard. Hearing that number, again. I thought we had seen the last of that for a little while. But for the listeners who have been regularly following Andrzej's appearances and for the new listeners, this is why you want to listen to this podcast. So hopefully you go on wherever you're listening to the podcast, subscribe, give us a review, give us a «thumbs up», a «like», a five-star review, whatever it is. Because if you've been listening to Andrzej and his previous two appearances, he laid all of this out in his unique level of ability to articulate these ideas in very simple terms so that you could actually take this out and implement these strategies. And he's just been bang on over the last couple of months. Now, you're in a position to, like you say, take some profits and let's see how this plays out. Andrzej, I have another big question longer term as we talk about higher debt levels and a comfort taking on higher debt levels. Both candidates likely, but Trump, he's got his four years, he's probably not that worried about the deficit. We talked a little bit about it. But when does the bond market finally look at debt levels in the US and just say, enough! Are we anywhere near that? Or is talk of that just overblown? Or will there be a point where you just get to so much debt in the US that the bond market says, we’re just not going to take these yields that we're getting right now. We want more. Do you see that anywhere on the horizon?

From our perspective, we'd say that one of the reasons why the back end of the curve, while longer duration, 10-30 treasuries have been underperforming of late, is because the market is sending a signal that they see on the horizon a ton of supply that needs to be absorbed to fund those deficits. That's why you might need to see higher yields to entice investors to find a clearing level for that supply to be absorbed. If we're looking at a number of markets, whether that's swap spreads in the US or whether that's a difference between the REPO and SOFR rates, they're sending a bit of an alert signal that investors need more compensation to absorb the wave of issuance that will be coming our way. Clearly, market is taking into account the elevated deficit picture, and that is one of the key reasons why we're seeing steeper curves in the treasury market. Having said that, we don't think that over the next months and quarters, we will see the arrival of bond vigilantes and the market genuinely having a go at the US Treasury market and pressuring valuations to some dramatic degree, having a bias strike. We think that at these yield levels, between the household balances, between offshore balances, there's a lot of money sloshing around to absorb that issuance. It's just that investors are demanding higher yields for that to happen. For as long as US remains the reserve currency of the world, and for as long as US growth does not deteriorate dramatically, we feel that the risk of proper breakdown within the US Treasury market is very limited. Having said that, you could easily see a situation that, as the market is dealing with this wave of issuance, we will have individual auctions that might feel like it might not be an earthquake, but it's a tremor where investors will be sending a signal with higher tails and lesser demand at that particular auction to send a message to the Treasury Department. But we don't think that at this stage this will go beyond those one-off tremors into a full-blown crisis.

Then we watch inflation, and that will somewhat tell the tale in terms of how high yields may go without the bond vigilante he's showing up. I was going to use that term in my question. I passed, but you threw it in. Can you maybe explain to the listeners the idea of the bond vigilantes, who they are and what they do?

Well, essentially, when a large group of investors decides that US Treasury Department is vulnerable in its ability to place debt because either people are completely full-on risk or there is a bias strike at current levels, they can sense that and lead to very weak treasury auctions where levels are executed at yield significantly higher than where the market was trading prior to that auction. Then that is followed through with aggressive selling of government debt as other investors join the party, although I'm not sure party is the right description for what that would entail. But then you can imagine hedge funds piling in, shorting, treasury futures and putting additional pressure on the market to the point where some help needs to come, whether in the form of banks absorbing some of that excess supply or Fed or the Treasury Department thinking about solutions to the crisis. We don't think that we're at that stage yet. But as I mentioned, it will be a volatile rise because these will be very elevated deficits close to double digits by historical standards. The idea that this will be a smooth sailing is quite fanciful.

Yeah. This is really what we need to watch in terms of risks out in the market for not just the bond market, but also for the stock market, were that to come into play at some point. So just something to always keep in the back of our minds. And that's why a good, diversified portfolio is the approach that investors should be looking at and getting good financial advice around it. Andrzej, I did hear that you had dressed up as a bond vigilante for Halloween this year.

Who told you? That was supposed to be a secret.

I know where you live in Connecticut, everybody's in the finance business, in the financial services industry and investments. So that would be just a frightening outfit for your neighbors.

Well, trust me, seeing hordes of kids dressed as Taylor Swift was much more frightening to me than me dressing up as a bond vigilante. So my girls were not infused with my choice.

Excellent. Well, Andrzej, congratulations. I can't thank you enough for coming on and all the wisdom you share. I wish I could be so articulate and concise. I just don't have it in me, but you have it all the time. And we love having you on. And we'll check in with you pretty regularly from here on out because it should be a really interesting next 2-3 months as we move towards inauguration and get more ideas around policy and then go into 2025. So thanks, Andrzej.

Always a pleasure. You're always too kind, Dave. Good luck to your listeners as we navigate through these uncharted waters. I wish you all the best for the remainder of the year.

Well, they're in good shape with you on their side. So thanks, Andrzej.