Vers quelque chose de mieux ?
The Fed’s tightening cycle is underway. Bonds have performed very poorly. There is a chance that they do better going forward. Yields are higher that’s for sure. History suggests returns will improve from here. It all depends on how much the Fed suggests it needs to tighten. That depends on inflation. Of course, we could be heading to much higher bond yields and more big losses in fixed income. But I rather think that markets are setting up for an improvement in returns, at least for a while.
The first quarter of 2022 is nearly over, and it’s been awful. While the situation in Ukraine has impacted the growth outlook, inflation and the onset of monetary tightening has dominated markets. Compared to the last four Fed tightening cycles, this is already the worst in terms of fixed income market performance. The drawdown from the peak in bond market total return indices in the six months prior to the first hike has been worse in this cycle than in 1994, 1999, 2004 and 2015 periods. The initial response to the first hike has been worse as well. The question for investors is has this gone too far or is there more to come in terms of fixed income losses?
This cycle is different in that inflation is higher (both absolutely and in terms of the change in the inflation rate) than in the previous four cycles and the starting point for policy rates and bond yields lower. Thus, if the road map is that rates have to rise to match inflation, it is going to be the worst bear market ever. If the coming twelve months are to be as bad as the last year for the US bond market (proxy for developed fixed income), US Treasury yields will have to rise another 90-100bps. It can’t be ruled out. After all, government bond yields in the US and Europe are barely back to levels they were are at on the eve of the COVID pandemic. The market could eventually go beyond that. It is conceivable that we are at the beginning of a return to US 10-year bond yields to at least the peak of the last decade at 3% or even to the pre-global financial crisis (and QE) range of 4%-5%.
Or maybe relief?
Let’s not get carried away though as it is not clear that western economies could live with interest rates and bond yields rising that much in the immediate future. Debt levels are high. Policy makers won’t let it happen especially if it triggers rising corporate defaults or sovereign debt stresses in Europe, or emerging market defaults. From a market point of view there may be opportunities to buy bonds even if the medium term outlook is for higher yields.
Can you see the top?
In the last three Fed cycles, bond returns were positive again after six months. It took a little longer in the 1994-95 cycle when the Fed acted very aggressively raising rates from 3.0% to 5.5% in less than a year and didn’t really cut rates meaningfully again until after the 1999-2000 cycle. In all cycles, 10-year yields have peaked at, or just above, the peak in the Fed Funds rate. Today, the market is pricing in a peak of 2.75% for the Fed Funds, against today’s 10-year Treasury note yield of 2.36%. If the bond yield peaked at 2.75% that would translate to another 2.5%-3.0% loss in price. Assuming some carry (if the market yields peak in a year’s time), then the total return loss from here might only be around 0.5%. Of course, this is based on heroic assumptions that the market has got the peak in the Funds rate correct and market yields follow a similar trajectory (i.e. the curve is fully flat by the end of the tightening cycle). Credit would outperform, as it has done in all previous cycles.
The story in Europe is similar except the onset of the tightening cycle is further away. The spread between 10-year German bund yields and the ECB’s deposit rate is currently 100bps, the highest since 2013. If the deposit rate is moved to zero or above next year there is clearly some further upside for yields in intermediate maturities even if the curve flattens. However, long duration yields are probably starting to look attractive to liability focused investors in Europe. The 30-year French OAT yield is about to enter its pre-COVID trading range.
When the global supply curve shifts to the left and demand shifts to the right (basically the emergence from COVID plus the war scenario), then prices rise. It happens in aggregate and it happens at the micro level because supply is disrupted everywhere meaning shortages of inputs to which the rational market response is to allocate through the price mechanism. Reversing this means moving the supply curve back to the right (end of war, increased output in key sectors, workers returning post-COVID – all of which central banks can’t affect) and moving the demand curve to the left (raising the cost of credit – which central banks can affect). That is basically the policy road we are on, with a good deal of hopes and prayers that a soft landing can be achieved.
Soft landing or recession in 2024?
The odds aren’t good. In the 1970s and 1980s, recessions did start before the Fed had finished tightening but that was when inflation and rates were much higher and economies less flexible and global. Since the 1980s, the dating of the beginning of recessions has tended to come sometime after the last hike. At the time, policy makers thought they had delivered a soft landing but in time a recession was declared, starting anywhere from 6 to 17 months later. Because there is no visibility on a recession as yet, earnings forecasts are not factoring that in. Hence equities have actually performed reasonably well since the Fed hiked rates on March 18th. (Historically, equity prices fall more when the recession starts, and the Fed is cutting rather than ahead of the rate hiking cycle and the recession).
When the narrative changes…
If inflation is the dominant macro factor, bonds should be experiencing significantly normalised underperformance. The correction in the S&P500 relative to its historical volatility is not unusual relative to that seen in bonds (about 25% of the standard deviation of 6-month returns for equities compared to 80% for bonds over the last 40 years). Bond yields could still go higher but, again, the worst might have been seen in terms of losses. If the narrative does turn to recession the tables might turn, and multi-asset investors will benefit from higher bond yields providing a more effective hedge against equity returns than has been the case in the last year or so.
Diminishing marginal losses
I’m not saying markets are a “buy” right now. There remains so much uncertainty in the outlook that higher risk premiums are warranted everywhere. But we have had meaningful valuation adjustments and corresponding losses. For bonds the losses have been historically large. The way fixed income works is that for every further 10bps that yields rise from current levels, the total return hit will be less than it was when yields bottomed in August of last year. Higher carry and convexity make sure of that.
In the short term, inflation is going to remain high and that will support inflation-linked bond performance. There is more upside to interest rates and that means floating rate debt instruments offer an element of defensiveness with many also providing decent cash-flow because of their credit profile. For riskier factors – duration, credit, equity – it is not clear yet. We are moving towards buying opportunities – even if for shorter-term periods. Or even for longer. The UK inflation linked gilt due to mature in 2073 trades at a price 25% below its issue price. Might be a good one for the grandchildren. Low price and high coupon bonds, better quality short-duration high yield bonds, equities with earnings growth and low levels of debt. These are the investment opportunities for now in a market that has universally delivered more “value” than seen for some time.