The bond markets have been experiencing a turbulent patch. A range of factors have collided to create this disruption, including an adjustment to the ‘higher for longer’ narrative from central banks, a deluge of supply and the tentative withdrawal of ‘market insensitive’ buyers such as central banks. This could be a cause for concern, or a potential buying opportunity.
The message from central banks has been clear for some time: rate rises may be on hold, but they remain poised to raise rates again if the situation arises. New York Fed President John Williams said: “My current assessment is that we are at, or near, the peak level of the target range for the federal funds rate … I expect we will need to maintain a restrictive stance of monetary policy for some time to fully restore balance to demand and supply and bring inflation back to desired levels.”
Bank of England Governor Andrew Bailey echoed his comments: “We will need to keep interest rates high enough for long enough to ensure that we get the job done.” It is a message trotted out by central banks across the world. The problem is, until recently, markets have chosen not to believe them, assuming that there would be rate cuts some time in 2024.
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A major reason for the recent rise in bond yields is that investors realise that central banks could be serious. Kristina Hooper, chief global market strategist at Invesco, says: “Treasury yields on the short end, such as the 6-month T-bill yield, were relatively flat on the assumption that the Fed will probably not need to hike rates again. But the view that rates will be higher for longer has caused treasury yields on the longer end of the yield curve to rise significantly. The three-, five-, and 10-year US treasury yields rose to their highest levels since 2007 last week. And the 30-year US treasury yield rose to its highest level since 2011.”
However, this is not the only factor at work. Markets are also anticipating a glut in supply. Luca Paolini, chief strategist at Pictet Asset Management, says: “The move in yields was exacerbated by the prospect of a deluge of bond supply – the US budget deficit is running at 8% of GDP, while the costs of servicing existing debt are already eating up 14% of tax revenues.”
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Almost all developed market governments are facing a similar dilemma. Research from Fitch Ratings in July forecast that Britain would spend 10.4% of total government revenue servicing its debts in 2023. Interest payments are currently running at around double the level in the period to September 2021. The expectation is that governments will have to issue more and more debt just to keep the wheels turning.
This comes at a time when some traditional buyers are retreating. Central banks are trying to unwind their vast balance sheets. Steve Ellis, global chief investment officer, fixed income at Fidelity International, says: “The buyers in the treasury market have changed. Issuance for years was sucked up by long-term holders – chiefly the Fed itself and other central banks – who were relatively uninterested in the price of what they were buying.
“With the spike in yields, the big added buyers of the past year instead are US households and asset managers. Money market fund buying also jumped again in the second quarter, as the troubles at regional US banks this spring underlined how falling bank deposit growth has reduced the demand for duration from commercial banks. All of this will have an impact on 10-year and other longer-dated paper.”
How much of this is temporary? Certainly, Ellis points out that rising yields runs contrary to the direction of travel on inflation. Core inflation continues to drop across the major developed economies and while there are risks, such as the rising oil price, most expect inflationary pressures to continue to ebb.
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Equally, Hooper says that central banks may not mean exactly what they say: “It behoves central banks to talk down markets and stamp down any positive fervour as they attempt to sustainably control inflation. But those are just words and dots, not sticks and stones. We could be pleasantly surprised that developed central banks are not that high for that long after all.”
There are mounting signs of weakness across many major economies – particularly the UK and Europe. BlackRock Investment Institute talks of a ‘stealthy stagnation’, pointing out that there is a significant difference between US GDP and GDI (gross domestic income). It believes GDP is likely to move lower, closer to GDI levels over time. In particular, it believes, retail sales figures appear inflated.
Paolini agrees, saying that recent industry surveys point to a drop in services consumption. This represents 70% of economic activity in the US. He adds: “Non-residential investment is also likely to fall because of high interest rates and a tight labour market.”
The other problems may prove more intractable. Central banks are unlikely to change direction on QT and neither is there likely to be any immediate let-up in the pressure on government finances. Hooper says it may be that markets need more proof on the deflationary narrative, “in particular, we’re looking for more signs of an economic slowdown in the US, as that will help dictate when rates will begin to be cut next year and by how much.”
Nevertheless, Paolini believes that some value has emerged in long-dated treasuries. He adds: “At around 4.5%, yields on benchmark 10-year treasury bonds are at levels last seen some 15 years ago.”
The most likely scenario is that this is a one-off adjustment. Markets had started to look surprisingly unprepared for anything other than a soft landing, and a drop in rates next year. It could be argued that they have now adjusted to the potential for ‘higher for longer’ rates and are better appreciating the risks.
