Bond markets have taken a battering the last few years. The losses were so great at one point in time that it was compared to the losses incurred in some of the greatest asset market collapses in history but certainly the greatest bond market crash in recorded history. All that seems to have turned on a dime with the latest Federal Reserve meeting which traders worldwide have taken to mean that peak rates are now behind us and we are looking at heading lower once again. Is this too optimistic a picture to paint? Are these just traders ‘speaking their position’? Might there be some way to take on board some risks at this juncture in the wake of such a disastrous period for the bond markets?
Part of the problem- a major part of the problem one might say, is that the ground conditions don’t really give an all-clear for loading up on debt right now. Certainly, a large part of it is the central bank saying that they don’t plan on raising rates any further and that they can foresee a path towards lower administered rates going forward with inflation now receding. Further, a large cross-section of the market seems to think that rate cuts will be forced upon the Federal Reserve if they are to avoid a recession next year. Swap markets are already pricing in 140 basis points of cuts by December of 2024 so bond markets look poised to make back a chunk of what they have lost the last two years of pain.
And it isn’t just the US where this is applicable. The latest UK inflation print (CPI for the year in November came in at 3.9% versus the October figure of 4.6%) pushed the Pound lower against the Dollar on the expectation of a faster and earlier rate reduction programme by the Bank of England. The EU inflation print for November came in at 2.4% versus 2.9% for October signalling the easing pressures there as well. The danger for Europe is the uncertainty of energy prices as long as conflict rages on its edges between Russia and Ukraine. But the lower print will offer some hope that Europe may also be on the path towards lower administered rates sooner rather than later. Japan just reported a 2.5% rise in inflation in November year-on-year while China is experiencing deflationary pressures with their latest data suggesting a -0.5% change in prices compared to November 2022.
With global inflationary pressures easing is it likely that we will return to ultra-low rates and easy liquidity again? Very unlikely. It is true that inflation globally, which began 2023 at 3.5 times the 2% target- on average, that most G7 central banks share, it is now down to 1.5 times their target level. It is also true that many of these economies are struggling with growth or are predicted to tip over into recession next year. So, both the motive and the excuse are in place to ease rates and liquidity. So, why is it unlikely to happen?
Well, rates are expected to go lower and starting as soon as the end of Q2 2024 in all probability ceteris paribus. But will they return to the ultra-low/easy conditions? No. For the simple reason that those rates and Quantitative Easing policies and fiscal loosening were counter-active measures to the possibility of global commerce freezing up in the wake of the pandemic. Central Bank balance sheets ballooned to provide the liquidity that had ceased as leverage withered, risk was taken off the table and production faltered. Central Banks are in the process of slowly draining that liquidity- none more conspicuously and with telling effect than the Federal Reserve- upon whose currency the burden of much of surplus global liquidity lies.
Further, central banks are- in fact, more cautious in their language about rate cuts than most overeager market participants would have us believe. That may be because, after two years of being- for most market players, in completely unknown territory, are eager to get back to the known space of low rates, making huge profits as yields fall on their current holdings. The market may be running ahead of itself in this case.
Thirdly, and significantly, the current outstanding debt that governments must rollover are significant given the record levels of absolute debt. The issuances that the US Treasury will have this year have most market players divided as to what the yield curve for US Treasuries will look like in 2024. Estimates for the 10-year yield- which peaked above 5% this year, by end 2024, range between 3% (following 200 basis points of rate cuts) to 4.35%, with most of the larger banking institutions varying their forecasts in a range of 4% plus/ minus 10 basis points. This level has already been reached (currently trading at 3.88%) by the market before the rate cuts have even begun! That leaves little room for any play in the long end, highlighting the wariness of the market about the volume of debt that needs to be rolled over in the coming year (estimated at USD 770 billion of investment grade paper). In a scenario like this a shorter duration bet on 2-year paper (currently at 4.36%) seems a better likelihood of a decent pay-off.
The path to lower inflation seems clearer now than it did just 2 months ago. This will be a relief to bond holders who have ridden huge mark-to-market losses on their portfolios or booked losses. Corporates who have to rollover debt will also be hoping for a swift reduction in rates, as will mortgage seekers. But the likelihood of a full return to the low-interest era seems way too optimistic for the foreseeable future. And, with debt overhangs and government fresh issuances looming, the chances are for the longer tenor papers to remain offering high yields until some of that debt is pared down. This may happen over time as high costs push borrowers to other means of raising capital but until then, yield curves are likely to become upward sloping again.