Throughout this volatility, we shouldn’t lose sight of the downside protection that bonds will afford us if the attention shifts once again towards recession risk.
Government bond markets have been caught between oscillating narratives for several quarters. When recession fears have come to the fore, bond yields have fallen as investors priced in more aggressive central bank easing. Yet when the market’s focus turned from downside growth risks to upside inflation risks – perhaps thanks to fiscal largesse – the direction of bond yields has reversed. The net result from these push and pull factors has been for government bond yields to fluctuate in a range of 3.5%-5% for the last two years in the US and the UK, and between 2%-3% at a eurozone level (see Exhibit 17). This is a more volatile experience than perhaps we would expect from our prime ‘risk-free’ assets.
Looking forward, we expect some of this volatility to persist but we still think core bonds deserve their place in providing income and downside protection.
As we go to print, bond yields are nudging towards the upper end of this 3.5%-5% range as the markets focus on the fiscal package making its way through Congress and a somewhat concerning outlook for the trajectory of US government debt. Whether clients should buy bonds in a world in which governments don’t seem to care about debt is a key question frequently hitting our inbox.
It’s an understandable question. In its current form, the headline impact of the US fiscal bill is forecast to add around $2.4tn to the already sizeable $21tn expected to be borrowed in the next 10 years. To prevent a larger price tag, the bill includes back-loaded spending cuts, and classifies many of the tax cuts as temporary. The experience of the 2017 Tax Cuts and Jobs Act raises doubts about whether these temporary tax cuts really will be allowed to expire later down the line, while there are also questions about whether spending cuts to areas like Medicaid pencilled in for future years are politically feasible.
However, we think it would be challenging for US 10-year Treasury yields to move sustainably through 5% without inflicting significant macro disruption. With US mortgage rates already close to their highest levels since 2002, we would expect significantly higher yields to lead to tighter financial conditions which would in turn slow the economy over time (see Exhibit 18). Higher yields could also spark a sharp fall in equity prices, and given the close link between the level of the S&P 500 and consumer confidence, economic growth could therefore take another hit from weaker consumer spending.
While it might feel uncomfortable, we would therefore suggest leaning more into duration when 10-year US Treasury yields move closer to 5%.
Throughout this volatility, we shouldn’t lose sight of the downside protection that bonds will afford us if the attention shifts once again towards recession risk. Weakening labour markets would be the most likely catalyst for significantly lower yields. Sticky wage growth in many developed markets has been an important driver behind persistent services inflation in the post-pandemic era. For central bankers to gain greater confidence that upside inflation risks are being overwhelmed by weaker demand, a material rise in unemployment is likely required.
If this downside scenario for growth does materialise, it’s important to recognise that there is scope for the Federal Reserve (and others) to cut more aggressively than the market is pricing. Even if longer-dated bond yields fall by less than we have seen in previous cutting cycles, they would likely still outperform shorter-dated equivalents on a total return basis in this scenario. Bonds’ ability to diversify against a growth shock is therefore fully intact, and remains one of their most appealing characteristics in a multi-asset context (see Exhibit 19).
While we see reasons to find duration attractive when the US 10-year approaches 5%, we believe there should be a lower limit on yields below which bonds lose their attractiveness. More volatile inflation in a world of deglobalisation, more active fiscal policy, and changes to bond market structure are all reasons why in our view, the term premium – the additional compensation investors require for the risk of holding longer-term bonds – should be much higher than it was over the last decade (see Exhibit 20). There are also questions around the appetite for government bonds as safe haven assets given the correlation between stocks and bonds is no longer reliably negative.
While government bonds in other regions of the world are unlikely to fully decouple from US Treasuries, we would argue there are bond markets outside of the US where volatility in the coming year should be more contained. Gilts are arguably best positioned, given a relatively weak growth backdrop and a UK government that is much more constrained by its own fiscal rules. We are much more wary of the outlook for Japanese bonds, where a sustained improvement in wage growth has pushed inflation above target and there is still very little monetary policy tightening priced in by markets.
Eurozone sovereigns sit in the middle of this spectrum, with inflation much less of a headache for the European Central Bank but bond supply likely to accelerate to meet new fiscal spending. For European investors, the decision between US Treasuries and euro sovereigns is more likely influenced by the currency hedging considerations we explained in our chapter on the US dollar.
Assuming yields remain rangebound, income is likely to act as the key source of fixed income returns. This makes the additional yield on offer from high grade credit look attractive, with defaults and spreads likely to remain contained provided that corporate earnings continue to hold up (see Exhibit 21). After adjusting for changes in index quality, spreads are equally tight in both high yield and investment grade credit across the US and Europe. Given tight valuations and the balance of macro risks, we prefer to focus on high quality credit.