Year of the bond (delayed not cancelled)

It’s been a tricky three years for fixed income markets. This year was supposed to be the year of the bond after the biggest increase in yields since 2020. Instead, the market has given the doubters more reasons to question the value of fixed income. Let me be bold though. Next year will be the year of the bond. Yields are at multi-year highs; returns have been awful and the risk-return balance for putting money in today’s bond market is the best it has been for a generation. Of course, higher cash rates for now will remain a challenge but once central banks go down the more dovish route, returns will pick up. This time next year Rodney…

No 1973 yet

Market reaction to events in the Middle East has been muted so far. Whether that remains the case depends on political developments, speculation about which is beyond the scope of this note. If there are signs that the conflict is widening or that other actors are being drawn in, the most likely reaction in financial markets would be a strong dollar, higher gold prices and lower bond yields. Risk assets would come under pressure. Any kind of ceasefire or attempts by third parties to broker a deal to stop the fighting would allow investor attention to return entirely to the core questions surrounding inflation, interest rates and growth. Not to downplay the scale of the human tragedy, but from an economic point of view there is less likely to be the same kind of oil price shock that we saw around Middle East tensions in the 1970s - and the world economy is more robust to deal with such a price shock. It wouldn’t be good – we have a recent example of an energy price shock – but it would be very unlikely to usher in years of stagflation and awful real investment returns that characterised the 1970s.

Up and down

Bond markets have continued to be volatile. The global government bond index delivered five consecutive months of negative total returns to the end of September. This month is also running slightly negative, so getting positive total returns for 2023 is going to be tough (currently -1.4%) and an unprecedented third consecutive year of losing money in fixed income markets looks to be on the cards. The three-year accumulated loss on most fixed income benchmark indices is the biggest since most of those indices have been published (several decades). This week, markets did look to be trading better but then the release of a slightly higher than expected monthly change on the US Consumer Price Index (CPI) for September led to another (brief) sell-off. Yields are high still, relative to where they have been in recent years, and I continue to hold the view that these levels represent good value. The average price on the ICE BofA Global Government Bond Index is 88.3 cents, close to its lowest level “ever” (the index price peaked at 117.4 in early 2020).

Conundrum

I’ve recently had several conversations with clients around the conundrum over why 500 basis points of monetary tightening has not led to a more negative impact on global economies. Resorting to the assertion that monetary policy works with long and variable lags doesn’t really help when running portfolios. That process needs an element of time horizon to establish the optimal balance between expected returns and risks. My view remains that the longer central banks hold interest rates at the peak, the more likely it is that householders and companies will start to see more of their cashflow diverted to servicing debt. After all, debt levels are high. Moreover, governments are starting to feel the pinch by having to pay much higher coupons on new borrowing and, for some, having to indemnify their central banks’ losses that are resulting from paying interest on the bank reserves created because of quantitative easing. Fiscal balances look to be deteriorating in many developed economies, meaning fiscal policy will have to be tightened going forward. The boost to growth from pandemic-related fiscal largesse is coming to an end.

Housing is pivotal

Housing markets are crucial to the outlook for interest rates. In the US, the national average 30-year mortgage rate, according to Bankrate.com, is 7.8% - close to the highest of the last 25 years. Borrowing costs are higher today than they were in 2006-2007 (the last ‘Table Mountain’ era for interest rates). In the UK, the average two-year fixed rate is close to 6%, up from 1.5% at the end of 2021. Bank of England data on mortgage approvals show a softening of demand this year, with the latest monthly rate of 45,000 being well below the long-term average. Data from Nationwide Building Society shows average mortgage payments as a percentage of take-home pay is up to the highest level since 2009. The US has a different mortgage structure, but it seems hard to think that new borrowers are going to be lining up to pay 8% mortgage rates. New homes sales in the US are starting to move lower but we are yet to see much evidence of lower home prices.

In time, it hurts

I am of the view that it is a matter of time before higher borrowing costs eat more into household budgets, requiring consumer spending to be cut back. On the corporate side, given that I work closely with credit analysts and investors, it is not a surprise that higher rates have not yet caused a generalised problem. Companies were not stupid during the period of low yields. They locked into too-low interest rates and termed out their borrowing, allowing them to build up large cash piles (the remainder of which are earning 5.5% interest rates in money market funds). But new borrowing will come at a higher cost. The ICE BofA US 1–3 Year Corporate Bond Index has a historic coupon of 3.4% but a current yield to maturity of 6.1%. If yields don’t go down, borrowers will be refinancing debt when it matures at almost twice the interest rate of that paid on the debt taken out in the last three years.

What we know, what we expect

The issue is these things are slow moving. It is not like 2007 when the problem in the US was the large number of adjustable-rate mortgages that re-set into a higher interest rate environment. Getting detailed data on how many companies are facing higher rates on revolving bank credit, or what is happening precisely with the demand for new mortgages is not easy. Yet we know bank lending conditions are tightening, we know that UK mortgage holders that are re-setting today are doing so in the knowledge that their monthly payments are going to skyrocket, and we know that the cost of financing any investment project with new debt is much higher than it was three years ago. All of this must impact spending and hasten a slowdown, if not recession. Lower rates will then come.

House prices should contribute to lower inflation measures, eventually

Housing plays a role in the inflation outlook too. While the headline CPI for the US in September suggests some stickiness (the year-on-year rate was unchanged at 3.7%), the services excluding rent of shelter aggregate was a much more palatable 2.8% year-on-year (seasonally adjusted). This measure peaked at over 8% last September. The data show that the housing component of the CPI was still up 5.6% compared to a year ago. House prices are slow moving and that means the shelter component of the inflation data is also slow moving. Overall, the CPI measure excluding food, shelter and energy was 2.0%. Back to target 😉   

Higher risks for longer

Housing markets are interest rate sensitive. Developments in house prices can also distort the picture on underlying inflation trends. It becomes somewhat circuitous that inflation drives interest rates up which in turn eventually leads to weakness in the housing market which in turn then contributes to lower inflation (with a lag) and subsequently lower interest rates. One bond-bullish interpretation of the data is that, if we ignore housing, inflation is already close to being back at target and the Federal Reserve has no need to hike rates again. The next move should be an ease and that will come with the overall inflation rate being lower and further signs of slower growth. In the meantime, there is the possibility of a bad reaction to tighter monetary conditions that we can’t see now. In that regard, we will be closely watching US bank earnings reports in the next couple of weeks. My colleagues in the fixed income team have already noted a widening of credit default swap spreads on US bank names in recent weeks. The rise in bond yields over the summer could be an issue for bank balance sheets and earnings. We will see.

(Performance data/data sources: Refinitiv Datastream, Bloomberg, as of 13 October 2023). Past performance should not be seen as a guide to future returns.