Asset allocators have teed up 2024 as the year of the bond, but it is not a one-way street.
- Yields already anticipate some level of rate cuts
- Levels of national debt are high, giving bond markets a lot of issuance to digest
- The corporate bond market must also contend with low spreads
Fixed income looks like a sure bet for 2024. Yields are high, inflation and – potentially – interest rates are coming down. Yet there are reasons to be cautious. There are still a number of risks for the bond market in the year ahead.
Yields already anticipate some level of rate cuts. The US 10 year treasury yield has dropped from 4.9% at the start of November to its current level of 4%. The UK 10 year gilt has dropped from 4.5% to 3.8% over the same period. If these rates cuts don’t materialise, it could create some angst in the bond market. While the Federal Reserve has indicated rate cuts next year, the ECB and Bank of England continue to warn that investors shouldn’t expect them.
There is considerable debate as to whether central banks will risk cutting rates before inflation hits the 2% target. The expectation built into market prices is that central banks will cut as long as there is a clear path towards the 2% level. There would also need to be some weakness in the jobs market to force a slowdown in consumption.
There are other risks to the benign picture for bond markets. For most developed market government bonds the sheer weight of bond issuance to digest is a problem. The US national debt is currently sitting at nearly $33 trillion dollars, up almost 90% since the start of the pandemic. The annualised interest bill has hit $1 trillion, or 20% of tax income. More issuance is required just to keep pace with the level of debt.
The risk is that buyers start to dry up for US debt and the government is forced to pay higher yields to lure them back. US debt levels appear unsustainable, but there is little inclination from either flavour of government to reverse the tide: the Democrats want to continue spending, while the Republicans want to cut taxes. This will also exert some pressure on the bond market.
If there are risks for the government bond market, the corporate bond market must also contend with low spreads. Aggregate corporate bond spreads are their lowest in two years and don’t appear to reflect the potential for recession in the year ahead.
The current level of yield provides a good cushion for all these risks. However, fixed income may not be the one-way bet that investors anticipate in the year ahead.
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