A Bond Phoenix Rises from the Ashes
by Andrew Milligan | June 28th, 2022
This has been a horribly painful year for most investors. US equities have fallen into traditional bear market territory. Indeed, 2022 is turning into the 5th most volatile year for the US stock market since 1990. Sadly, there has been little safety in traditional safe assets — prices for government and corporate bonds have each tumbled sharply. The proximate cause is sharply rising inflation, forcing investors and central bankers alike to recalibrate the prospects for much tighter monetary policies. If market expectations for major interest rate hikes are correct, 2022 will witness the sharpest policy tightening since the 1980s. It is no surprise that economists are rapidly declaring that recession is just around the corner.
Looking beyond the short-term business cycle, a set of important long-term questions remain unanswered. As central banks slow asset purchases and shrink the size of their balance sheets, will bond markets be able to absorb the supply previously scooped up by global monetary authorities? What are the implications for bond yields and real rates of interest? How do economies with historically high debt levels cope with such increases in borrowing costs? And how should long-term investors, such as pension funds, insurance companies, or even individuals with long time horizons, view the attractiveness of fixed income assets in their portfolios?
This article begins to explore these issues. Depending on how certain parameters pan out, it would be no great surprise if the marketing departments of fixed income fund managers start to produce a stream of advertorials in the coming weeks arguing that now is a good entry point into their market. More important to look out for in the coming year would be any advice from long-term asset allocators and consultants, suggesting that the classic portfolios held by investors for many years should begin to evolve.
Over the past 18 months, bond yields have risen sharply. As recently as January, the benchmark US 10-year bond yield was about 1.5%. This past month it has tested 3.5%, its highest level for a decade, even if at the time of writing the yield has drifted back toward 3.1%. Other major markets have shown similar trends, with benchmark yields rising to 1.4% in Germany (from previously negative levels and to 2.3% in the UK, their highest levels since 2014–15.
A fundamental shift in the economic environment means that both major components of the nominal bond yield — inflation expectations and real yields — are undergoing considerable change. Central bankers have been well ‘behind the curve’ on inflation, underestimating its magnitude and duration. Last summer, the Bank of England forecasted that inflation would not move far away from its 2% target. Now it admits that headline inflation might reach 11% this autumn, leading to very public criticism from former central bank heavyweights Andy Haldane and Mervyn King.
Whilst the media often focus on current inflation and future expectations, emphasising shifts in oil prices or the state of the labour markets, the rise in nominal bond yields also reflects significant changes in the real (i.e., inflation-adjusted) yields. The US Treasury Inflation Protected Securities (TIPS) rate has returned to positive territory for the first time since 2019. The causes are many and various, but decisions by the Federal Reserve and other central banks to shift decisively away from quantitative easing to quantitative tightening must be a prime factor.
Indeed, it is noteworthy that while all eyes are on whether the Fed hikes rates by 0.5% or 0.75% at its upcoming meetings, its efforts to slim its $9 trillion balance sheet have attracted less attention. By September, balance sheet reduction will ensue at a pace of $100 billion a month. Academic research suggests such ‘quantitative tightening’ should lead to higher real bond yields. In addition, the US Treasury faces considerable financing needs over the coming 12 months when $6.5 trillion of the $30 trillion stock of US government debt will mature and will need to be rolled — without the Fed as a buyer of last resort.
Whether or not current bond yields, therefore, represent a good entry point depends on the results of careful scenario analysis and portfolio risk management. Making matters more challenging are unusual degrees of uncertainty, particularly concerning developments in Ukraine, China’s Covid-related lockdowns, and climate-related and other political shocks, to name but a few known unknowns.
Surprisingly, market expectations for terminal interest rates in Europe are not much above 2%, and for the USA not much above 3.5%. This is low in relation to previous monetary policy tightening cycles. The simple explanation is that the bodies such as the IMF and OECD, as well as many private sector economists, warn strongly of a pronounced global economic slowdown, reflecting monetary and fiscal tightening, supply chain problems, the Covid shut down in China, plus the squeeze on household disposable incomes and corporate earnings from falling real wages and compressing profit margins. The World Bank expects global economic growth this year to be as low as 2.9%. In the UK, the Bank of England forecasts the UK economy will show virtually no growth in the next 18 months. Day by day surveys of economists warns of a growing recession risk in 2022–23. Yield curves have flattened and even inverted.
Beyond monetary policy and the business cycle, a key signpost will be any changes recommended by pension consultants and strategic asset allocators to investment portfolios. For years, it has been a no-brainer for funds to be underweight fixed income. Yields were just too low, and valuations too stretched. At one time the value of government and corporate debt with a negative yield approached 30% of the global market. But that figure is now below 5%. Change is afoot.
Moreover, long-standing spreads are now narrowing. One example is the yield gap between US and Chinese bonds. The incentive to diversify into Chinese debt to pick up extra yield has all but disappeared. Outflows are reversing years of inflows. For much of 2020 and 2021 investors also benefited from a higher dividend yield on the S&P500 than the yield on government bonds. That is no longer the case. Meanwhile, credit spreads have widened, as rising default risk is discounted by investors.
All in all, the conditions are falling into place for a fundamental reassessment of the traditional 60–40 equity-bond portfolio, which has had a disastrous start to 2022. The reset of various asset prices in the first half of this year will force investors, consultants, and advisors to reconsider long-held views about return, correlation, and risk.
Given greater certainty about the growth and inflation outlooks, it would not be a surprise to see investors opt for increased exposure to relatively safe government debt securities. The end of zero interest rates, the collapse in the amount of debt with negative yields, and the replacement of QE with QT all suggests that a new fixed income era is emerging. The process may be haphazard and volatile, reflecting the volatility of consumer and investor confidence, but at the margin, professional investors and their advisers are likely to look again for returns in fixed income markets. And a shift in private sector attitudes could facilitate the transition from quantitative easing to quantitative tightening. That would be no bad thing.