Benstead on Bonds: the next leg down for bonds could just be beginning

Bonds got off to a roaring start this year, but reality is beginning to bite for fixed-income investors. 

The bond market has quietly reversed its gains for the year as investors begin to price in stickier inflation and higher interest rates for longer.

This comes after a euphoric spell for fixed income since October 2022 as inflation – particularly in the US – began to sharply drop off and the market consensus was that there would be interest rate cuts by this summer.

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Yields – which move inversely to price – fell sharply from October to the end of January, but have now kicked higher.

The yield on the 10-year UK government bond fell from about 4.5% in mid-October to 3% at the start of February – but is not at nearly 4%. The US 10-year Treasury offers a 4% yield compared with 3.5% at the start of the month.

Bond markets are repricing because inflation looks like it may take longer than expected to fall back to the 2% central bank targets. Higher inflation means higher interest rates, which is bad news for bond prices.

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Central bank spokespeople had been making it clear that they would not loosen monetary policy too soon and interest rates would not be likely to fall this year – but markets did not believe them. Now, their message is getting through loud and clear. 

Stuart Edwards, fund manager in Invesco’s bond team, notes that central banks do not want to make the same mistakes of the 1970s and let inflation get out of control.

He said: “Economic data suggests inflation has peaked, but components within it, particularly on services like rents, are proving to be sticky, as well as food prices. There is still lots of demand in the economy.

“It will be a rocky path to low inflation now as the low-hanging fruit of cheaper commodity prices from a year ago has moved already.”

The Bank of England says that inflation risks are “skewed to the upside” and that “persistent inflationary pressures” will be met with further tightening of interest rates.

New data from the US supports the view that the steep drops in inflation could have already come. The US Commerce Department reported that the core personal consumption expenditures index (core PCE) rose 0.6% in the month of January, and was up 4.7% year-over-year, versus Wall Street estimates of 0.5% and 4.4% respectively. The index excludes food and energy costs in the US, making it a useful measure of sticky price changes.

Greg Wilensky, head of US fixed income at Janus Henderson, says the new data was not good news for inflation watchers, and could be an indication that the trajectory of inflation back down to the Federal Reserve’s 2% target is likely to be more bumpy – and prolonged – than markets expect.

“Following three months of falling inflation, investors had become complacent in their expectations for a continuation of the downward trend. We expect markets to adjust to the likelihood that the Federal Reserve will need to raise rates higher, and keep them higher for longer than they had been pricing previously.

“Viewing the hotter inflation data together with continued strength in the labour market and consumer spending implies that the Federal Reserve still has work to do on the inflation front,” he said.

Janus Henderson now thinks that another 25-basis point rate hike is highly likely at the March US Federal Reserve meeting, with the possibility of one or two more at subsequent meetings depending on data releases in the coming months.

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Deutsche Bank has also shifted its inflation and interest rates forecasts. It expects a peak (terminal) US interest rate of 5.6% in July, up from 4.7% today, with four more rate hikes likely to get them there.

Three things tipped the bank to change its views: a strong US jobs market, less disinflation than expected, and financial conditions not tightening enough to transmit interest rate policy sufficiently.

Greg Pesques, chief investment officer for fixed income at Amundi, adds that we are getting closer to a pivot from central banks. Under this scenario interest rates could be used again (by being lowered) to boost economies and react to systematic shocks. However,  Pesques does not think we are there yet as central banks are worried about making a policy mistake.

“At central banks, the hawks will battle the doves if there is a shock to the system. The hawks will be opting to kill the beast of inflation whatever the shock is, while the other camps will be more pragmatic. Central banks need to keep their credibility and will be hawkish overall,” he said.

Therefore, it is looking like 2023 will be the year of uncertainty when it comes to inflation, with stock and bond markets reacting furiously to data as it comes out. But 2024 is likely to be more predictable as the impact of interest rate rises really begin to take effect.

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Edwards calls 2023 the “year of transition”, while 2022 was all about the inflationary surge and 2024 will be about downside risks to economic growth as rate hikes feed through.

So, with much more volatility to come from bonds as inflation expectations whipsaw, what should investors do?

Investors looking for an alternative to the stock market can finally get a good, low-risk yield – so they should focus on the income available from bonds rather than trying to predict moves in inflation and therefore bond prices.

Buying bonds that are due to mature soon could be the savvy move. They are less sensitive to interest rate changes, and due to an inverted yield curve, they actually yield more than longer-dated bonds. This looks like a great opportunity for investors seeking stable income amid economic and stock market uncertainty.

Edwards agrees with me: “Buy for the yield not capital gains as prices could be volatile. This environment no longer forces people into stocks – cash is king when it pays you 5%, which is the yield on short-term US government bonds. This is a game changer and effects everything,” he said.