Bond market pain reintroduces some value
- Persistently strong economic data and above-target inflation has left the Fed with little choice regarding its stance on policy
- Government bond yields have risen to multi-year highs, but this heralds a return of value and credit markets looking attractive
- Overall bond portfolio returns will likely rely much more on coupon income than on outsized capital gains
This summer's bond bear market has been painful. Government bond yields have risen to multi-year highs primarily because of concerns that interest rates will remain high for a significant length of time.
The good news is that this has brought value back into the bond market; it has improved the probability of long-duration strategies being able to outperform cash going forward - which has not been the case so far in 2023. Such an outcome requires long-term yields to move down again. But that depends on the current narrative of a soft landing for the US economy to be challenged.
For that to happen, we need to see the labour market weaken and consumers rein in their spending. So far, it has been consumer resilience which has surprised economists even when manufacturing has been in recession, housing markets have softened, and bank lending conditions have tightened.
Current 10-year US Treasury yields are high relative to long-term inflation expectations, with real yields close to 2.0% - their highest levels since before the global financial crisis. They are also high relative to the level indicated by the long-term relationship between trend-nominal GDP growth and the implied risk-free borrowing cost. This would suggest a yield of around 3.6% compared to the current 4.3%.
Deviations of actual, from fitted yields – i.e., forecast yields, have tended to happen during Federal Reserve (Fed) interest rate hiking cycles. However, we do seem to be close to the end of this cycle as inflation rates are falling. Rate cuts might not be around the corner but when they do come, long-term government bond yields will retreat. However, let's not get too excited.
Immediate returns and concerns
The ability of bonds to deliver positive returns in the next few months may be limited by several factors. First, interest rates could still move higher. The Fed and other central banks have welcomed lower inflation, but inflation remains well above central bank targets. Additional rate increases from here, or at least an expectation that rates will remain high well into 2024, would hinder bond performance.
Second, economic data remains robust. Consumers are not caving into higher interest rates, certainly not when they still have jobs and are still enjoying rising incomes. Without weaker consumer spending, the economy likely avoids a recession and rates stay high with the Fed sensitive to any signs that progress on reducing inflation has stalled. Most US labour market data suggests the jobs market remains healthy. In most macroeconomic models, a rise in unemployment is a necessary condition to get inflation back to target.
In time we will have a better understanding of why over 500 basis points (bp) of monetary tightening has not had as big an impact on the US economy as those economic models would suggest. It could be the lags between policy decisions and activity have lengthened. It may be because household and corporate balance sheets are stronger. For now, a recession is not underway and, therefore, there is no need to cut rates. The recent increase in yields reflects that.
The persistence of strong economic data and above-target inflation leaves the Fed with no room to signal a softening of its monetary stance. There is more uncertainty over the path of interest rates going forward compared to what has been the preferred scenario of many investors - that the 2022-2023 tightening would cause a recession to be quickly followed by looser monetary policy. The uncertainty requires a higher term premium in the outlook for risk-free rates, hence higher long-term bond yields. The divergence of actual yields from the nominal GDP model implied yield reflects this uncertainty.
The third set of factors challenging the long duration trade are more technical in nature. The federal deficit is forecast to be $1.7trn in 2024. That means a lot of borrowing by the US Treasury. At the same time, the Fed is reducing its balance sheet, and as the bonds it holds mature, they will not be replaced by new purchases. Other technical considerations include the impact of the change in Japan's yield curve control policy and China's attempts to support its own currency (by presumably having to sell US dollars). I doubt these things are materially impacting Treasury bond prices, but they certainly play into the negative sentiment.
This year was supposed to be a better year for bond investors after two consecutive years of negative returns. For many fixed income strategies, it is turning out to be disappointing. Higher yields give investors another chance to bet on the recession and a lower rates scenario, but disappointment may persist in the short term. Not all is lost though. Short-duration strategies are delivering positive returns and potentially should continue to do so.
The upside of the economy doing better than expected is that credit markets appear attractive, offering a higher return than government bonds. Corporate and financial bond issuers have been able to manage the increase in borrowing costs and concerns about balance sheets and the ability to service debt are largely absent. A high percentage of bonds in issue are also trading at a market price below par. But the ‘pull to par’ will eventually deliver better returns for bond investors.
A new backdrop
The world has changed. It has become harder to forecast how the global economy will fare given the long shadow of the pandemic and the inflationary shock it helped provoke. The return to a world of 2% inflation and stable growth, with central banks willing to cut rates when growth and inflation were seen to be too low, is very unlikely. Higher future equilibrium interest rates are implicit in today's market pricing. If there is no significant recession, then the behaviour of inflation will be very different to the 2010s. Central banks’ model policy setting will be to prevent inflation rising rather than worrying about it being too low.
The interest rate environment could be defined by rates being, on average, higher than over the last 15 to 20 years. Changes in policy rates might become more frequent if inflation rates are not consistently below target ranges. A higher average and more frequent changes in policy rates might also be consistent with narrower ranges for interest rates – certainly compared to the more than 500bp increase in the Fed Funds Rate in this cycle.
Bond performance won't always be disappointing. But there is a need to accept that bond yields will be higher than they have been for many years, and bond portfolio returns are going to likely rely much more on coupon income than on outsized capital gains driven by aggressive rates cuts or central bank buying. I don't think we will see US Treasury yields at 6% but nor do I think they will fall below 3%. That's a range wide enough to cope with the ‘new normal’ business cycle and for active fixed income managers to generate returns worthy of any portfolio.
(All data as of August 2023. Source: Bloomberg)