2024 was supposed to be the year of the bond, but to date, it hasn’t been. Economic data has been stronger than expected, and inflation readings higher. Central bankers have continued to talk tough and dented hopes of an early rate cut. This has left bond markets down on the year and may have caught investors off-guard.
We consider the advantages and disadvantages of global bonds in the year ahead and what that could potentially mean for portfolio construction in 2024.
Advantages: yields remain high
Fixed income still has a number of factors in its favour. Yields are high relative to recent history and even higher after the recent weakness. Across the UK, US and Eurozone, 10-year government bond yields are around 0.5% above their level at the start of the year and double their level of 18 months ago*. Corporate bond spreads over government bonds are still low relative to the past two years, but not compared to the longer term, and there is – as yet – nothing alarming in default rates**.
Equally, there are some historic parallels that suggest the timing may be right for bonds at the moment. Jim Leaviss, manager of the , acknowledges the recent weakness, but adds: “When the Fed is about to start cutting interest rates, that has been the time to load up on US treasuries, gilts, and credit…The Fed has said it will cut at least three times this year. The historical average is that eight months after the last hike, comes the first cut. March would be exactly eight months after the last rate hike from the Fed. If it’s not March, it may be May or June.”
He also points to the amount of money sitting on the sidelines, particularly money market funds, which currently hold around $8 trillion in cash***. “The FOMO is kicking in – bonds and equities have rallied. And if interest rates go down, those treasury bill rates will go down too. People will want to get back into the market.” Cash will no longer be as appealing.
Disadvantages: caution on rate cuts
However, there have been concerns that too many rate cuts are already embedded in bond market prices. The US CPI reading for December came in higher than expectations (3.2% versus 3.1% predicted****). In the Eurozone, inflation climbed to 2.9% in December, from 2.4% in November^. In the UK, inflation rose marginally to 4% in December, up from 3.9% in November^^, after economists had predicted a slight fall.
While these rises are marginal, central banks continue to guard against complacency. The recent Bank of England minutes showed two members of the Monetary Policy Committee voted for more rate rises at the recent meeting^^^. Fed chair Jay Powell recently warned that the committee, “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably towards 2%”^^^^.
Dickie Hodges, manager of the Nomura Global Dynamic Bond fund, says investors need to pay close attention to this central bank guidance, and particularly the Federal Reserve. He says: “The rate cuts are not coming imminently, and in the case of the ECB there is no confirmation yet that they are coming at all. So, with five to six rate cuts in 2024 being priced-in by markets on both sides of the Atlantic at the start of the year, we believe the market is getting ahead of itself and open to disappointment.” His view is that rate cuts will begin around the middle of the year.
Is 2% inflation close?
Jim Leaviss is more optimistic that the 2% target is close: “Inflation has started collapsing – both core inflation and headline inflation. The numbers that the Fed looks at – core PCE (Personal Consumption Expenditure) inflation – are back down towards 2%. Inflation is going in the right direction.”
His worry is longer-term, believing the US election could create a potential problem. Historically, there has been a natural stabiliser effect between GDP and bond yields. Governments borrow more when the economy is weak, he says, and when the economy is weak, inflation is lower and interest rates are generally falling. “But this relies on a world in which governments borrow more when economies are weak, not where they borrow more to juice an already strong economy.”
The US economy is flying, but the potential re-election of Donald Trump in November is likely to cut taxes. “The biggest contributor to the rise in debt to GDP has been tax cuts. That will mean more bond issuance. This might be quite good news for risk assets such as equities and credit on day one. But after that, people will start worrying about the amount of bonds being issued.” For this reason, Trump’s election could be inflationary and is a longer-term worry for bond investors.
Portfolio implications
In the meantime, Jim Leaviss believes that the greatest opportunity lies in longer dated bonds. He says: “The Fed say that long term interest rates, based on demographics, technology, globalisation, and those long-term factors that determine how much we save and invest, should be around 2.5%. The bond market thinks it’s more like 5%.” Dislocation at this level is rare, he says.
Dickie Hodges has been increasing hedging in the Nomura portfolio to protect against short-term volatility, but believes the US will ultimately cool and give scope for rate cuts. He is also adding selective duration risk: “We expect the materialisation of rate cuts in 2024 to lead to lower bond yields on both sides of the Atlantic. A large part of the move lower has occurred and the (expected) short-term caution means that we expect the path lower to be anything but smooth.
“We expect the overall positive environment for fixed income assets to be reinforced later in 2024 by a partial reversal of the enormous flows we have seen into money market funds. We have allocated duration risk to the 5–7-year part of the US and European yield curves, which should be the most price-sensitive.”
2024 is probably still the year of the bond, but markets had got ahead of themselves and were vulnerable to an adjustment. If anything, this may make them more attractive, removing some of the froth from the market and re-setting expectations at more sensible levels. Sensible, flexible managers should be able to steer a path through the noise.
*Source: MarketWatch, as at 9 February 2024
**Source: ICE BofA US Corporate Index Option-Adjusted Spread, as at 7 February 2024
***Source: M&G Investments, January 2024
****Source: FT, 11 January 2024
^Source: Eurostat, 1 February 2024
^^Source: ONS, 17 January 2024
^^^Source: Bank of England, Monetary Policy, 1 February 2024
^^^^Source: Bloomberg, 1 February 2024
