Economic Commentary

Is an end to the global bond sell-off in sight?

2022 is proving to be a painful year for global bond investors, with the iShares global government bond exchange traded fund (ETF) falling around 22% since the beginning of the year1.

Given the inverse relationship between the price of a bond and its yield, capital values have fallen as rising inflation and higher interest rates have prompted a sharp upward move in bond yields. The sell-off has been particularly brutal, as inflation has been higher and more persistent than generally expected at the start of the year.

In turn, policymakers, having previously been complacent regarding inflation risk, have embarked on a game of catch-up, hiking interest rates aggressively in a bid to rein in price pressures. The most influential central bank, the US Federal Reserve, has instigated its fastest rate hike cycle in recent history, while signalling further increases ahead2.

In recent weeks, volatility unleashed by the UK government’s ill-fated mini-budget has compounded pressure on global bond markets.
Against this backdrop, the yield on the benchmark 10-year US Treasury bond has risen to 4%, up from around 1.5% at the start of the year and its highest level in 14 years3.

The question now facing investors is whether the relentless upward climb in bond yields is likely to abate any time soon. The answer hinges on whether bond markets are now adequately pricing in central bank policy moves going forward, a factor which is in turn dependent on the inflation and growth outlook.

Inflation outlook

Take the inflation outlook first. Upside inflation surprises have been a key driver of higher yields this year. In the US, higher service sector prices resulted in a stronger-than-expected rise in core inflation to a multi-decade high of 6.6% in September4.

However, the consumer price index is what is known as a lagging indicator (an indicator that tells us what has already happened) and more timely leading indicators suggest that inflation should fall back through next year as the economy weakens.

Easing supply chain pressures and elevated inventories are now putting downward pressure on prices for consumer durables after last year’s steep gains5. And the latest PMI survey for the US services sector showed selling prices rising at their slowest pace since the end of 20206.

Moreover, the quirks of statistical methodology used to calculate housing, or shelter, costs within the CPI means that there is a considerable lag before the official inflation data captures what is currently happening on the ground.

To illustrate, the shelter component was a key driver of monthly inflation in September, rising 0.7% m/m. However, with the housing market cooling dramatically in recent months, private sector data show that both house prices (down 0.44% m/m in July according to the S&P Case-Shiller index7) and rents (down US$12 during September according to realtor.com8) are now falling.

This suggests that although the shelter component will continue to boost inflation in the coming months, its impact should diminish in 2023.

Interest rate expectations

In turn, the prospect of slower inflation and weaker economic activity suggests the steady upward revision to interest rate expectations witnessed in recent months should lose momentum. Following recent strong labour market and inflation data, markets currently anticipate that the Fed will raise its policy rate to 4.75-5.0% by spring of next year from the current 3.0-3.25% level9.

Interestingly, this peak or ‘terminal’ interest rate is above the 4.6% level at which rates were forecast to top out in the Fed’s latest economic projections, published in September10.

Against the backdrop of increasing financial stress and a deteriorating economic outlook, some of the rate hikes priced in by investors might not happen. Various leading indicators, such as PMI manufacturing new orders11 and an inverted yield curve12 (long-term yields trading below short-term yields) point to a high probability of recession over the next 12 months or so. And given that monetary policy impacts the economy with ‘long and variable lags’, it is reasonable to expect that the Fed will at some stage pause its rate hiking schedule to take stock.

To be sure, a desire to oversee increased slack in the labour market to curb underlying inflation pressures will make the Fed wary of loosening policy prematurely (see our commentary of August 2022). However, as concerns over recession come to the fore, investors are likely to price in the prospect of eventual interest rate cuts, which should translate in to a pull-back in bond yields.

The UK’s fiscal U-turn

The upward pressure on global bond yields emanating from the UK’s mini-budget debacle should also start to dissipate. With the new Chancellor, Jeremy Hunt, reversing most of the tax cuts announced on 23rd September, as well as scaling back support for household energy bills and penciling in departmental spending cuts, investor fears of a large, unfunded fiscal splurge have eased. At the time of writing, the yield on the 30-year Gilt was trading at 4.3%, down from a peak of 5% seen on 27th September, but still higher than the 3.8% rate which prevailed prior to the mini-budget13.

It is too early to declare that the UK is out of the woods yet. The government still needs to find further budget cuts, the Bank of England (BoE) has terminated its emergency bond purchases, and the potential for further pension fund selling of Gilts remains a wildcard. Moreover, as it stands, the BoE is still on course to resume active sales of Gilts (so-called quantitative tightening, or QT) on 31st October, a factor that could put upward pressure on yields given prevailing febrile conditions.

However, the government’s U-turn on fiscal policy suggests less need for dramatic monetary tightening from the Bank of England in order to keep inflationary pressures in check. Prior to Chancellor Hunt’s announcement of 17th October, markets were pricing in a rise in the BoE’s Bank Rate to 5.6% by mid-2023 from the current 2.25% level14. It now seems unlikely that the BoE will push rates that high, not least given that the economy is already contracting15. Downwardly-revised rate expectations should in turn be supportive of UK government bonds.

Better times for bonds?

It is too soon to declare with any confidence that the recent rout in global bond markets has run its course. Central banks remain focused on reining in inflation and appear prepared to keep hiking interest rates despite the darkening economic outlook. Moreover, the Fed is only in the early stages of reducing its holdings of US Treasuries and mortgage-backed securities (MBS), allowing its balance sheet to shrink US$95 billion per month by not reinvesting the proceeds of maturing bonds.

There is also growing speculation that the Bank of Japan could relax its policy of yield curve control (YCC), under which the authorities seek to prevent the 10-year Japanese government bond yield rising above 0.25%. With the BoJ’s YCC policy having served as an ‘anchor’ for global yields, any lifting of the cap could have ramifications beyond Japan’s shores.

This said, a large degree of monetary tightening is already priced into UK and US bond markets, and with yields now at multi-year highs, the asset class is starting to regain its appeal as a source of income and a portfolio diversifier. A rising inflation environment has hit fixed income investments hard this year, but government bonds typically do well as economies slide into recession. This year’s rout should provide the set-up for a better total return performance in 2023.

18th October 2022