‘What is different this time?’: Experts debate a delayed ‘year of the bond’

In 2022, bond markets saw one of their biggest declines on record but higher yields, falling inflation and the prospect of interest rate cuts buoyed bond markets at the start of 2023, with experts dubbing it the ‘year of the bond’.

By the end of Q1, experts were already pulling back on this view, and at the end of bonds’ ‘year’, managers are facing their third straight year of losses for the first time in roughly four decades.

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“Investors could be forgiven for rolling their eyes at a fixed income investor calling the peak in yields,” Matthew Morgan, head of fixed income at Jupiter Asset Management, said.

A year ago, the US Treasury 10-year yield had just fallen over 50bps, having peaked at 4% in October, and credit “looked more attractive” than it had since 2009, with a recession “sure to come in 2023”, Morgan said.

This year, US 10-year yields have fallen over 50bps again, after peaking at 5% in October. Credit was yielding more than it has for a decade, Morgan added, with a recession again predicted for the coming year.

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The UK also repeated its 2022 path, as UK 10-year gilt yields closed in on another 15-year high.

Last year, yields suffered their highest daily rises in decades in the aftermath of Liz Truss and Kwasi Kwarteng’s Mini Budget.

“I could forgive readers a little scepticism: what is different this time?” Morgan said. “I would argue we are in a different place, despite the familiar pattern.”

Duncan MacInnes, manager of Ruffer Investment Company, pointed out that when gilt yields touched 5% post-Mini Budget “the world was ending…it was chaos”, but when the same thing happened in Q3 2023 the bottom did not fall out of markets because it had been reached “in a more orderly fashion”.

“It is the debate of rate of change versus level of change,” he said.

Inflation forecasting mismatch

That did not take away from the level of volatility experienced this year, demonstrated by MacInnes salesout of the fund’s entire 10% position in US 10-year Treasury Inflation-Protected Securities (TIPS) in early December, just a month after initiating it. He also halved his duration exposure from 8%, having raised it from zero, after the bond market moved by 1%.

The volatility was partly due to markets confidently pricing in a series of rate cuts next year, although some managers did not share in the consensus outlook.

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Even before the Fed began holding interest rates at 5.25-5.5%, markets had begun pricing in a series of “aggressive” rate cuts in the US for summer 2024, according to Gäel Fichan, head of fixed income at Syz Group.

This went against the previously persistent narrative from Fed chair Jerome Powell “telling you they are not going to cut rates”, MacInnes noted, even if inflation had declined the past 12 months.

But the Fed switched to more dovish messaging at its last policy meeting, with new forecasts from central bank officials pointing to 75 basis points of potential cuts next year.

Fichan said markets were pricing in a set of cuts around 120bps in 2024, “anticipating both a decrease in inflation and some economic deterioration (inverted yield curve)”.

This would favour the front end of the yield curve, as it is “the most sensitive part to inflation and monetary policy”.

“On the intermediate/long end of the yield curve, the impact would hinge on how the economy holds (soft/hard landing or remains robust),” he added.

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This was still a relatively “optimistic” outlook for inflation though, according to Kevin Thozet, a member of Carmignac’s investment committee, despite the late, dovish tone from central banks.

Falling inflation had given central banks “breathing room”, according to Morgan, and Edward Harrold, fixed income investment director at Capital Group, added that if inflation stabilised “this should correspond to a more stable rates environment with rising expectations for cuts in rates to come in 2024”.

“Such an environment should be broadly positive for fixed income assets, and investors may want to consider a pivot away from inflation-linked assets in pursuit of higher-yielding opportunities,” Harrold said.

However, “timing this shift precisely is almost impossible”.

What happens to TIPS when inflation falls?

TIPS were pipped as one of the primary defensive allocations against climbing inflation, as Harrold described, but with inflation coming down, Fichan argued TIPS were “currently at highly attractive valuation levels”, offering a real rate superior at 2%, a level not seen since 2008. This compared to -1% at the beginning of 2022.

He said there was still value in holding the asset “as a strategic component” of his long-term strategy, even with declining inflation.

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Harrold echoed this, adding that given markets had set a “high bar” for inflation’s path next year “we cannot yet dismiss the risk of seeing a reacceleration in inflation, [so] investors may want to consider holding a modest allocation to TIPS”.

But it was not just higher inflation environments which favoured TIPS, according to Robin Marshall, global investment research director at FTSE Russell.

He said it was an “investing myth” that higher inflation automatically favours inflation-linked assets.

“One of the apparent paradoxes of the 2022-23 inflation shock was under-performance of ‘inflation hedges’, like inflation-linked government bonds and real estate.”

Four Graphs explaining government bonds

Marshall pointed out that inflation linked gilts, along with bunds and US TIPS, “performed best” during periods of low but stable inflation, when policy rates are near zero, such as the period following the Global Financial Crisis and in the early stages of Covid.

“So, the best outcome for inflation linked assets may be lower inflation in 2024, allowing rates to fall,” he said.