At the start of this year, it became increasingly clear that government bond markets may have been over-optimistic about rate cuts, particularly as the corporate bond market appeared simultaneously to be pricing in a buoyant outlook for growth. During January and February, there has been a significant adjustment, but might bond markets have now gone too far the other way?
The bond market has been giving conflicting signals. On the one hand, the government bond market was pricing in significant rate cuts, which implied a markedly weakening economic outlook. On the other, corporate bond spreads over government bonds were tight, suggesting that the market did not see an imminent rise in defaults.
These disparate views from different parts of the bond market have now been largely resolved. The yield on the 10-year US treasury has risen from 3.9% at the start of the year to its current level of 4.2%. Expectations of interest rate cuts have been pushed out. This puts government bond markets more in line with corporate bond markets, where spreads continue to be low.
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However, this poses a different question for fixed income investors. James Ringer, fixed income portfolio manager at Schroders, says the more pressing discussion for his team is whether markets have now overshot. The bond market is both cause and effect. As the US Federal Reserve started to talk about rate cuts in November last year, it pushed government bond yields lower. This created an effective stimulus in the market, which “greased the wheels of the economy,” says Ringer. “The market narrative has shifted quickly. The market has priced out the probability of a hard landing.”
A hard landing still looks unlikely. The January non-farm payrolls report showed ongoing momentum in the US labour market, and the latest GDP figures also showed broad strength across the US economy. Ringer says: “The non-farm payrolls report was huge and wage growth was buoyant as well. That set off a chain reaction, compounded by the CPI report. A number of data releases shifted people from one side of the boat to the other in very short order.”
However, he adds: “When that happens, there is typically an overshoot. We’re currently debating the extent of that overshoot.” They still see the rate of wage inflation falling to a level more consistent with central bank targets. They still see inflation falling, even though there is a blip. “The market may have gone too far in pricing out a no landing versus a soft landing, and has also gone too far in pricing out a hard landing.”
In portfolios
While that means that government bonds look better value, there are still some parts of the corporate bond market that look stretched. In particular, Ringer highlights US dollar-denominated investment grade bonds. “They are now approaching the lows in credit spreads seen when the central bank had just created a bond purchasing programme. We prefer European investment grade credit, where spreads are not at historically tight levels.”
Donald Phillips, co-manager on the Liontrust Strategic Bond fund, is underweight both investment grade and high yield. Investment grade exposure was reduced by 10% during January to 42% – their neutral position is 50%. They have a small underweight in high yield – 18% versus 20%. “The economy is slowing down and credit is priced for perfection,” he says.
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Nevertheless, he says the outlook for credit is still benign and they remain poised to add to their credit holdings if there are periods of volatility. He says high yield is higher quality than it has been historically, and the overall yield is still attractive. He is focused on the BB or B area of the market and on sectors where there appears to be some mispricing. He would include areas such as real estate in this. While there are some obvious problems with the office market, “the baby has been thrown out with the bath water, particularly in Europe”, he says.
Nevertheless, he believes government bonds now look attractively valued, with a relatively high yield. The fund remains longer duration, at seven years, and he believes interest rate cuts are still coming down the track. He admits they were a bit early, but, “we are paid to wait”.
Different regions
There is also a question over whether there is a greater gap opening up between individual regions. While the US continues to record strong economic growth, the UK and Eurozone are flirting with recession. This is likely to bring inflation down harder. Yet their government bond markets continue to move in lockstep.
The assumption is that the Europe and UK markets will not be able to cut ahead of the Federal Reserve. However, Ringer believes the ECB and Bank of England may be more independent than markets believe: “Where central banks aren’t as independent is where the economic is highly sensitive to the currency – more a feature of the developing world. I would like think the Bank of England and ECB have a degree of independence from the Fed.”
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He believes that central banks will follow their own mandates and whichever central bank feels most confident on the inflation trajectory will cut rates first. This suggests that the overshoot may be more acute in the UK and Eurozone. Dickie Hodges, head of unconstrained fixed income at Nomura Asset Management, for example, has been reducing duration, with the notable exceptions of intermediate German bonds and long-dated UK bonds.
Ultimately, a soft landing remains the most likely scenario, given the data. However, there are risks on either side, and the market may now be under-pricing the risk of a negative outcome for economic growth, particularly in the UK and Europe. Corporate bonds and government bonds appear to be moving to a more harmonised view on the economic outlook over the next few months.
