The journey to a new rate regime
Interest rates have sold off sharply in the second half of 2023 and volatility is likely to remain for now. The good news is that inflation is retreating. The two key remaining questions are therefore: How long will the journey to the new normal be? And what will this new normal look like? Be prepared and embrace change.
By Michel Vernier, CFA, London UK, Head of Fixed Income Strategy
Please note: All data referenced in this article is sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.
- The big question for bond investors remains whether rates will continue to rise in the same fashion as seen during 2023
- The good news is that global inflation has been on the retreat for some time now which makes significantly higher policy rates, and substantially higher long end yields, less likely in our view
- The crucial question now evolves around the longevity of the journey towards the ‘new normal’; potentially reached in 2025 or even further out. Furthermore, uncertainty remains over how the new normal will look like
- Higher anchored yields compared to the last decade seem likely. But equally nothing gets eaten as hot as it gets cooked. We see opportunities in a volatile market. Embracing dislocation and volatility to maintain higher income, but also to explore price opportunities, seem like the appropriate way to invest in the bond market during this journey.
Anatomy of a sell-off: a recap
After subdued performance in 2021, and clearly disappointing performance in 2022 (with almost every segment showing double digit losses), 2023 was meant to be a more rewarding year for bond investors. Unfortunately, as things stand, most bond indices remain on a downward trend spurred by higher rates.
As we published our Outlook a year ago, global rates re-priced sharply on the back of fiscal uncertainty in the UK. As a result, UK 10-year gilts rose from 1.9% to 4.5% in a matter of two months. Interestingly, 10-year gilt yields are at similar levels today.
Five months later, the US financial system was rocked as several US regional banks succumbed to higher yields and a mismatch between their asset and liability duration. Then, fears of spill-over caused yields to retreat again.
The conclusion is that the negative repercussions associated with a spike in rates tend to limit the extent to how high rates can go.
Fixed income markets’ performance and yields
The recent performance and evolution of yields for various fixed income segments
From short end to long end
The surge in yields during this cycle was first driven by higher short-end yields, something which coincides with historical patterns. This part of the yield curve had to acknowledge during 2023 (as previously) that the US Federal Reserve’s (Fed) hiking exercise wasn’t over yet as inflation remained sticky and the job market tight. Instead of early rate cuts, as priced in back in March (150 basis points (bp) to 4% by end of December 2024), the Fed called for policy rates to stay “higher for longer”. We have pointed to this complacent market pricing many times during the last 12 months.
In the second half of the year, the long end of the curve started moving, driven by three main factors. The first culprit was the significant imbalance between demand and supply of US government debt. Indeed, as the US treasury signalled that supply was going to increase meaningfully over the coming quarters, the Fed and foreign buyers were both reducing bond purchases. The situation was made worse by the rating downgrade of US debt from AAA to AA+.
The second driver behind the rise in yields was the re-evaluation of the so-called neutral rate. In other words, the policy rate the central bank is trying to navigate to once the Fed can call victory over the fight of inflation. Also known as “r-star”, this neutral rate represents an equilibrium state with near-to-full employment but no overheating of the economy.
If this holy grail rate (anchor) ends up being higher than previously expected, the long end of the curve has no choice but to reflect that higher anchor point in today's rate level. The third and last factor is evidence of a more resilient US economy.
Glass half full
Although one may be tempted to get carried away after the bond market has witnessed its largest sell-off in recent history (Bloomberg US treasury +20 year index has lost over 45% since July 2020), investors should look ahead. After this great re-pricing (as illustrated in table 1) most bond segments now offer their highest yields in 15 years.
For buy and hold (to maturity) investors, this is certainly good news. Admittedly, high yields do not prevent yields from going higher still. But, over the medium to long term, an increased probability of lower rates could drive returns beyond what current yields suggest.
In the subsequent sections, we look at potential drivers for the short and long end of the curve.
Assessing the short end path
The short end of the curve is usually determined by the central bank’s policy path and the expectation of the respective path. At this stage, the forward rate market is not fully pricing in a further hike and implies almost 100bp worth of cuts by the end of 2024. As highlighted previously, history shows that, on average, the Fed holds its policy rates at the terminal peak for around six months, although it has varied between cycles. Should the Fed initiate its easing cycle in the third quarter 2024, as many expect, this would imply a roughly 12-month long plateau.
This may seem a long time but, in reality, the current economic cycle is somewhat unique and could justify such a long, or even longer, pause. Indeed, the unprecedented monetary and fiscal support has led US households to build significant excess savings while the unemployment rate remains historically low and higher mortgage rates have yet to filter through to the housing market. As a result, US consumption has and could remain healthy for longer than expected.
This is probably why, as illustrated by the gradual rise in the 5-year forward breakeven inflation rate (from 2.2% in June 2023 to 2.4% today), the rate market increasingly believes that the Fed may need to do more in order to bring down inflation towards its 2% target.
Bend it without breaking
While any further increase in rates may compromise an economic soft landing, history shows that inflation can be tamed only when the economy has cooled off significantly. In fact, in the last 50 years, only once has the Fed managed to quell inflation without breaking the economy. This was in 1994. Back then however, the Fed acted quickly and did not hesitate as long as it did during the current cycle.
Consequently, some repricing potential at the short-to-medium part of the curve persists.
Although it has been delayed, a loss of economic momentum is still expected to materialise. Indeed, tighter financial conditions should ultimately curb consumer spending and slow credit growth. As such, while the Fed may not reach its inflation target by the end of 2024, PCE core inflation is likely to settle not far above it either, according to our estimates.
The premium in the long end
Meanwhile, bond yields at the long end are likely to remain subject to the factors we mentioned previously, including the absence of price insensitive buyers such as the Fed or foreign institutions.
As a result, the premium that investors require for holding longer-dated bonds, the so-called term premium, has increased since the summer and is likely to prevent a deeper inversion of the curve. In fact, it could lead to a more pronounced steepening once the Fed starts its easing cycle.
That said, and in the absence of another crisis, the US debt pile is unlikely to jump again as much as it did in response to the pandemic. As such, the risk of a significant increase of the premium demanded, seems to be contained.
What to expect from long end yields
Overall, long-end yields have some more room to re-price higher, driven by both a potentially higher policy rate, as well as a greater term premium. Importantly, long-end yields have not yet been close to the peak policy rate level, something we’ve often seen in previous cycles. However, a US 10-year yield close to 5.5%, or even 5.75% (the potential policy rate peak), seems unlikely as markets would likely start pricing in an increased risk of recession.
Rate volatility has the potential to push 10-year yields towards levels witnessed during the rate hiking cycle in 2006 of around 5.25%, but at this level, longer dated bonds would start to look attractive to many long-term investors. Such a scenario would be supported by historical patterns: With the exception of 1980 when another hiking cycle followed, in the last nine hiking cycles 10-year yields retreated in the following 18 months after the Fed’s last hike (albeit historic performance is never a guarantee of future performance).
Yields tend to fall once the Fed is done hiking
The evolution of the 10-year US movement bond yield 12 months before, and 18 months after, the peak of various Fed hiking cycles
Long-end rates may not match the policy rate this time
US 10-year government bond yields and the upper target for the Federal Funds rate across ten hiking cycles
While uncertainty remains, the end of the hiking cycle seems very close. Rather than hiding away from volatility, investors may want to embrace it. In other words, while maintaining a core position in medium term duration to “lock in” yields, periods of dislocations should give investors opportunities to selectively extend duration and unlock further value.
Admittedly, higher duration brings higher price risk, but at this stage of the cycle, the scope for a large upward move in yields seems more contained. On the flip side, should the economy weaken significantly more than expected, long-end yields may adjust quickly and reward investors. In the context of a diversified portfolio, this may prove a valuable hedge against downside risks.
UK and European rates
Moving on to Europe, higher central bank policy rates in the eurozone appear less likely after the surprise hike by the European Central Bank (ECB) back in September. While inflation may heat up due to increased energy prices, financial conditions are markedly tight. The ECB must take into account the risk of recession, as well as the challenges posed by higher rates to highly indebted countries such as Italy. In fact, we see a significant risk of elevated volatility in the Italian debt market should monetary conditions tighten further.
Meanwhile, UK bond yields might not seem cheap on a real basis given the persistently high inflation. However, just like the ECB, the Bank of England (BoE) must find a balance between fighting inflation and not pushing the UK economy into a deeper recession. A further hike still seems possible but the threshold for this to happen appears very high at this stage. As a result, yields appear somewhat capped. That said, the long end remains exposed to bouts of volatility given the BoE’s need to sell outright gilts in order to normalise its balance sheet.
Beware of value traps
With higher bond yields on offer, investors should watch out for value traps. These appear to be concentrated primarily within the high yield segment. While US high yield bonds offer an average yield of 9.3% (8.6% in Europe), spreads have remained relatively contained throughout 2023 – although they have started to show signs of life recently.
Within the highest beta part of the market, spreads are prone to continue to widen in 2024. According to Moody’s rating agency, US speculative-grade companies have $1.87 trillion of rated debt maturing between 2024 and 2028, up a significant 27% from the previous record of $1.47 trillion (2023-27). Although, the maturity wall of 2025 and 2026 may seem distant, markets tend to look ahead and many of the most leveraged companies will have to absorb a much higher interest burden from then. Default rates in the US may not spike as a result but a gradual rise well over 5.5% (from 2.9% currently) could be sufficient to cause spreads to widen notably.
Focusing on higher quality issuers within the investment grade segment remains a more prudent strategy. This is even more relevant when, in the US, investment grade bonds are offering yields (6.3%) not too dissimilar from the long-term average returns seen in public equity markets. In addition, and unlike their high yield peers, investment grade issuers were able to term out funding needs to much longer maturities, and can consequently better withstand the recent rise in rates.
The maturity wall in high yield and investment grade
The maturity distribution for both high yield and investment grade issuers over the next 10 years
Look out for alpha
This is not to say that investors should avoid the high yield segment altogether. It’s about being aware of value traps and being selective. US Dollar BB-rated bonds, for example, still yield over 8% on average, and these bonds often stand on more solid credit metrics and a better funding profile compared to lower quality issuers within the segment.
Similar yields can also be found in financial subordinated debt instruments which due to their complexity and inherent risks are often overlooked. Being selective and using strategies and solutions to explore alpha would appear to be a reasonable approach. This is also true for emerging market bonds where value can be found selectively.
Uncertainty is unlikely to disappear in 2024. Investors should be prepared to experience further volatility and ultimately, be ready to embrace it. Next year, income opportunities could morph into price (i.e. capital gain) opportunities, also providing hedging benefits. As always, diversification will be essential. Meanwhile, investors will need to avoid value traps and look out for alpha within high yield and emerging markets.