HUB EXCLUSIVES PANEL DISCUSSION 2023 – AFTER THE STORM: GOVERNMENT BOND MARKETS
Panel discussion, hosted by Cherry Reynard, with:
Hilary Blandy, Investment Manager at Jupiter Asset Management,
Ed Harrold, Investment Director at Capital Group
and Connor Godsell, Investment Analyst at abrdn
After a dramatic adjustment in 2022, it has been a more stable period for government bond markets. For the first time in a decade, they appear to be back to normal, providing yield, capital protection and diversification once again. However, the recent turmoil in the banking sector created renewed volatility. Are government bonds a source of stability, or are there still potential surprises on interest rates and inflation?
- Markets are expecting central banks to start cutting interest rates soon
- Central banks are still guiding for a later turn in the interest rate cycle
- In spite of recent volatility, government bonds can assume their traditional role in a portfolio
After a dramatic adjustment in 2022, it has been a more stable period for government bond markets. For the first time in a decade, they appear to be back to normal, providing yield, capital protection and diversification once again. However, the recent turmoil in the banking sector created renewed volatility. Are government bonds a source of stability, or are there still potential surprises on interest rates and inflation?
Until the latest turmoil, bond markets were showing an unusual pattern, with short-term rates significantly higher than long-term rates – an inversion of the yield curve. This means investors expect rates to rise and then to fall sharply, a sign of impending recession. The banking crisis shifted expectations. Hilary Blandy, investment manager, fixed income at Jupiter Asset Management, says: “In recent weeks, we’ve seen shorter-dated bonds collapse. That suggests markets are expecting central banks to start cutting quite soon. Their view is that the turmoil in the banking sector will have the effect of tightening credit conditions.”
Inflation
However, for rates to start falling, inflation would need to drop considerably from its current levels. Bank of England Governor Andrew Bailey, for example, says he expects inflation to fall to 2.9% in the latter part of 2023. The Federal Reserve is also expecting a significant fall, as natural resources prices drop. However, neither markets nor central banks have been good at predicting the path of inflation and data has consistently wrong-footed economists.
Ed Harrold, investment director, fixed income at Capital Group says: “In January, we thought we were looking at the other side of inflation. There was a strong rally in January and that reversed through February. The market has been demonstrating a strong consensus that inflation falls quite quickly, citing reasons such as falling energy prices. However, there are questions around what happens going into next year. We don’t know what’s happening next winter, for example, and there are significant structural changes.
“We suspect inflation is likely to remain higher for longer. In the labour market, for example, unemployment still low and only just starting to see some signs of weakness. Goods inflation is easing, but services inflation is still strong. The recent UK CPI figures shows the potential for upside surprises.” Hilary agrees that the inflation legacy from Covid is still not clear. The effect of structural changes such as working from home is still being assessed.
Falling interest rates?
Is the market right that rates will start to fall shortly? There has been a growing gap between the guidance from the Federal Reserve and market expectations. Markets are now pricing in the first US rate cut as early as July, while the Federal Reserve is still saying there will be no cuts before the end of the year.
Connor Godsell, investment analyst, fixed income at abrdn, says the market may have got ahead of itself: “The US is currently pricing a cut of 100bps by the end of the year, which we think is optimistic and not consistent with a 2% inflation target. Current market pricing is stretched, but markets are reacting very quickly to new information. Data prints are becoming more of a swing factor. We believe rate cuts are likely to be later in the US than currently priced.”
The role of government bonds
While there may be short-term adjustments to rates, there can be little question that bond markets have substantially normalised over the past year. Harrold says: “Last year was the first year in 40 years that bond and equity markets declined at the same time. As a result of that repricing, we can expect more normal behaviour from government bond markets. They should be an offset to the volatility we see in equity markets, provide a more reliable income stream. As the interest rate cycle turns, there is the potential for duration to become a tailwind rather than a headwind.”
Blandy agrees: “Over the last 20 years, bonds have been negatively correlated to risk assets. Over the past two years, that negative correlation completely reversed. This feels very alien, but looking further back, in times when the primary concern for markets is inflation, this positive correlation isn’t unusual.”
“As people have worried about the health of the banking system, that negative correlation has come back. For me, government bonds are a good hedge against further stress in the banking system and offer yields not seen for some time. If an investor believes we’re through the worst on inflation, there’s the potential to make great returns from longer-duration bonds too, though that’s a more binary trade.”
However, selectivity is still important. Harrold adds: “In terms of developed market duration, we favour Dollar over non-Dollar, partly in relation to the real yield story. We have higher conviction for a steepening US curve, so overweighting the front end and underweighting the longer end. That should work if we see a cutting cycle, or if the Fed can’t hike because of financial stability concerns.”
Government bonds have seen a significant repricing over the past 12 months. In spite of some recent volatility, higher yields allow them to play their traditional role in a portfolio, as a source of income, stability and diversification. There may be surprises ahead on interest rates and inflation, but the more significant adjustment is behind us.
