"Higher for longer" is not enough to explain this phenomenon
Both fascinated and frightened, bond investors are hesitating
Combining strategies allows exposure without taking too much risk
CHART OF THE WEEK: "Rising yields usually end with something breaking"
BOND MARKET ANALYSIS
Bond yields have just reached very high levels (see Fig. 2), and very quickly (see Fig. 3). The most famous of all, the 10-year US Treasury yield, hit 4.88%, a record since July 2007, a far cry from the 3.29% it posted in May. Its main European counterpart, the 10-year German Bund, passed the symbolic 3% mark. If rates continue to rise, the risk of a major economic and financial crash will become increasingly likely, as has been the case in the past (see Chart of the Week).
The meteoric rise in yields can be explained in part by investors heeding the rhetoric of central bankers. Jerome Powell, Christine Lagarde and their counterparts in the major developed countries are hammering home the message that their key rates, the main tools of monetary policy, will remain "higher for longer". So, every time a piece of good economic news is published, the possibility of monetary easing recedes. Mechanically, the level of long-term rates rises to converge with that of short-term rates, steepening the yield curve (bear flattening). This was the case, for example, with the reassuring publication of US employment figures and the industrial purchasing managers' confidence index. The equation is simple: if the economy is resilient, then rates will remain high. Good news for the economy is therefore seen as bad news for investment.
Admittedly, bond investors have been slow to accept the "higher for longer" rhetoric, but this explanation is not sufficient to justify the recent rise in yields. The bond market is facing a structural problem, which we have dubbed the "Grey Rhino" (see WIF 30 January 2023). Not only is public debt gigantic, but a large proportion of the bonds used to finance it (27%, or €6,200 billion) is due to mature in 2023. As the State's budget is not in surplus, these bonds must be rolled over. However, the Treasury Department is behind schedule with its bond issue programme this year, particularly during the debates raging in Congress over the debt ceiling. According to our estimates, the US Treasury has only rolled over 1,700 billion in bonds so far. This leaves 4,500 billion to be placed between now and 31 December. Demand for US bonds may be very strong, but it does not appear to be sufficient to meet the colossal supply. This imbalance is causing rates to rise. The more lyrical will say that the Grey Rhino is starting to move.
Buyers of Treasury bonds can be divided into five categories: The Fed, foreigners, banks, pension funds (public and private) and households (including hedge funds). When the central bank withdraws from the market (see Fig. 4), the others demand higher yields to fill the gap. The more lyrical will say that many small fish are needed to substitute for the "Whale" (see WIF 27 March 2023).
As a direct consequence of the rise in interest rates, the performance of sovereign bonds, which had been catastrophic until October 2022 and then very good between November 2022 and April 2023, is once again disappointing. The US sovereign bond index has just given back the 7.5% it recently gained (see Fig.5). The only reason that performance is no longer negative is because of coupon payments. They provide(at last) a buffer against the depreciation in the face value of bonds when interest rates rise. This is not a trivial point, and investors should be pleased about it and take it into account for their future allocations. Unfortunately, for those who had opted for very long maturities, this is not enough. With greater sensitivity to rising interest rates, the losses are substantial. Cumulatively, they now equal those of the stock market indices during the Great Financial Crisis in 2008-09.
Fascinated by the attractiveness of current yields but frightened by the idea of seeing them even higherin a few months' time, bond investors are hesitating. Should they take or wait? The risk of yields rising further is real and is not about to dissipate, given the imbalance between supply and demand.Nevertheless, there are many arguments in favour of bonds :
▪ Firstly, a further rise in yields, particularly a violent one, would only be temporary.
Paradoxically, the higher yields are, the greater the risk of breaking something in the economy, and the greater the likelihood of a "pivot". If the recession is too severe or if the banking system becomes unstable, regardless of inflationary pressures, central banks will be forced to reverse their monetary policy by cutting rates. This is a classic phenomenon. Historically, the pauses between the last rate hike and the first rate cut have always been short, between 6 and 14 months (see Fig. 6).
▪ Secondly, long rates are close to their theoretical equilibrium value.
Robert Solow, Maurice Allais, Edmund Phelps and their followers established that growth is only optimal in the long term, without excess unemployment and inflation, if bond yields are close to nominal economic growth. For two decades now, 10-year rates have been below the annual rate of economic activity (see Fig. 7). It would be surprising if they were to rise much higher, especially at a time when economic activity and inflation are slowing.
▪ Thirdly, duration risk appears more attractive than credit risk.
The yield spreads between corporate bonds and Treasury bills do not reflect the current stress, linked to the increase in the number of bankruptcies and the volatility of the bond market (see Fig. 8). High yield spreads are definitely too low. As for yield spreads between peripheral European countries and the German Bund, these have only just begun to widen (see Fig. 9).
▪ Fourthly, steepening the yield curve is an interesting strategy for diversifying bond allocation.
It doesn't matter whether short rates fall, as they usually do when a recession is approaching, or whether long rates rise, as they are at the moment for the reasons outlined above. In both cases, "bullsteepening" or "bear steepening", investors reap the rewards of products or funds indexed to the steepening of the yield curve. After more than a year of inversion (see Fig. 10), it is time for "preference for the present" to take its rightful place. Unless we anticipate further increases in key central bankrates or a fall in 10-year yields, the steepening of the yield curve seems obvious.
The performance of sovereign bonds is once again disappointing. The risks ahead are not insignificant, butshould they materialise, the returns that follow would be even better. Combined with the holding ofsovereign bonds, a strategy indexed to the steepening of the yield curve moderates the sensitivity of the bond allocation to rising interest rates, while maintaining the expected return.