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Traders Eye Fixed Income

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The S&P 500® is coming off one of the best years it’s seen in decades, the Dow Jones Industrial Average is knocking on the door of 30,000 after only 2 years in the 20,000 range and traders are unsure whether the party’s ever going to end.

While there’s no telling when the current rally might abate, a large contingent of cautious traders has started the New Year hedging some of the market’s euphoria by seeking exposure to fixed-income funds.

Direxion’s Daily 20+ Year Treasury Bull 3X Shares ETF (TMF) has experienced more than $20.5 million in net inflows in the initial weeks of 2020. Meanwhile, the broad market Direxion Daily S&P 500® Bull 3X Shares ETF (SPXL) has shed a net $45 million in that same span as traders locked in profits from the index’s stellar fourth quarter.

A Big Year for Growth (and Debt)

The fact that 2019 was a huge year for price gains in both equity and debt instruments puts bullish and bearish traders alike in an interesting position. While SPXL ended the year up more than 100%, Direxion’s two 3X fixed-income ETFs, the Direxion Daily 7-10 Year Treasury Bull 3X Shares (TYD) and TMF finished 2019 up 16.77% and 38%, respectively. What’s more, they often moved inverse to the SPXL, usually seeing some of their biggest moves as equities fell.

The price action in 2019 is in part thanks to three consecutive interest rate cuts from the Federal Reserve aimed at encouraging borrowing and staving off recessionary threats like slow global growth and the U.S- China trade war. While the cuts fueled borrowing among companies and enticed investors to maintain their exposures, they also pushed bond yields lower across the board and buoyed the price of existing bonds that come with a more attractive rate.

What’s more, the grim global outlook in 2019 also prompted international investors to seek out the steady yield from U.S. treasury notes that, although historically low, come with a better yield than other government debt instruments that carry negative rates.

When Uncertainty Reigns

Although Wall Street is currently enraptured in another staggering rally, the increasing interest in fixed-income does hint at the potential for turbulence as 2020 gets underway.

That’s because despite the improved performance of equity investments through the latter half of 2019 and the initial days of 2020, uncertainty still abounds about the resilience of the global economy. Most traders are already well aware of the high valuations and diminished outlook many companies have outlined for their upcoming fiscal year. Additionally, the latest and most optimistic projections from the International Monetary Fund anticipate similar growth trends and risks that characterized 2019, including trade hazards and diminished growth from developed nations.

Another emerging trend furthering the likelihood of increased volatility is currently playing out in the futures market, specifically VIX futures. While CBOE’s Volatility Index has plotted a steady course to year-lows, February VIX contracts surged into the new year and put the spread between January and February contracts at more than 4 points.

The options curve smooths over heading into March, which itself represents another drastic shift in spreads that could cause a reverberation effect in the stock market. In any case, the high price for near-term contracts puts the relative calm the market is seeing now into fairly stark relief.

These fundamental headwinds are capped off by an already raucous election year in the United States and the ongoing impeachment trial of the sitting U.S. President. As that political chess match plays out, the market may begin to fray at the edges. Especially as some candidates from the Democratic side like Sens. Bernie Sanders and Elizabeth Warren gain traction and cause anxiety on Wall Street for their extreme regulatory and economic proposals and President Trump threatens to continue his policy of trade protectionism.

Debt Is King

What do these obstacles mean for fixed-income? For the time being, U.S. bonds and treasury notes remain the safest and highest yielding investment for institutional and international investors to hold. While bond prices likely won’t see the same kind of shot in the arm they did last year with the three interest rate cuts, rates are also not likely to rise and push prices down.

That fact underlies the current market rally, which has seen the S&P 500® tack on 15% since the start of October despite few fundamental catalysts. The point is, there is a lot of optimism on Wall Street at the moment, but at the edges there remain a lot of warning signs as well. If and when volatility strikes, the first place investors have looked for safety recently has been with U.S. debt.

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