After a brutal 2022, bonds are back in business. Central banks are coming to the end of their tightening cycles, inflation is starting to moderate, and market optimism is slowly returning. Challenges and uncertainties remain, but could the stage be set for a bond rally later this year? Here, we explore what a bond renaissance could means for investors and the Nutmeg portfolios.
Why did bonds go down in 2022?
Last year, central banks responded to rising inflation with rapid and aggressive interest rate rises. Bonds are sensitive to inflation and interest rates, as they erode their value. Investors duly sold bonds, driving their prices down, and their yields up.
The pace of interest rate hikes was so fast and starting yields were so low that nearly every segment of the bond market experienced sharp declines – making 2022 the worst year for the asset class since 1994.
Chart 1: Year-on-year bond price performance (1991-2022)
Source: Nutmeg/Macrobond, January 2023
The silver lining is that 2022 restored the income component of this asset class. As interest rates rose, so did bond yields. With central banks expected to finish raising interest rates later this year, government bond yields should stabilise, which is good for the broader bond market and supports investor confidence.
Starting yields are now the highest we’ve seen in years, and the level of return they are offering is attractive relative to other income investments such as dividends. This means that bonds can not only contribute more meaningfully to portfolio returns, but also be more effective in providing diversification.
Will bonds recover in 2023?
A sense of optimism is returning to bond markets. According to a Bank of America Survey, in December, money flowed into fixed income funds, with managers favouring bonds relative to other asset classes for the first time since the 2008 Global Financial Crisis. Cooling inflation has raised expectations that central banks may soon finish hiking interest rates, which would support government bonds and credit markets.
We think the path for fixed income and the extent of a bond market rally will depend on two factors: cyclical and structural.
Cyclical pressures should start to ease
Central banks go through cycles of ‘tightening’ and ‘loosening’ their monetary policy.
They tighten policy when inflation is high, and the economy is overheating, by raising interest rates and selling government debt (which is also known as ‘quantitative tightening’, or ‘QT’). They loosen policy when the economy is contracting and needs help growing or expanding. They do this by lowering interest rates and buying government debt (also known as ‘quantitative easing’, or ‘QE’).
Last year, central banks tightened monetary policy to lower inflation. It is starting to have an effect, meaning there may not be much more tightening to do in 2023. Proprietary research by Nutmeg indicates that we are in the late stage of monetary policy tightening, which is when bond markets tend to begin a long-term rally. It is at some point during these phases that bond yields begin to fall (meaning prices begin to rise).
However, bond rallies tend not to begin until the market is comfortable that interest rates have peaked. Central banks spend a lot of time signalling the interest rate they are targeting, and the future interest rate rises they intend to make at regular meetings. This communication is known as ‘forward guidance’.
Markets interpret these signals and respond accordingly – but professional investors also use economic data to try and guess whether central banks will need to do more or less than they’ve indicated.
At the moment, economic data suggests that inflation is beginning to fall, convincing markets that central banks may not need to tighten as far as they’ve suggested. This means that there is some disagreement between markets and central banks over future interest rate rises, and in turn, when a bond market rally can begin.
The red lines in Chart 2 below show the forward guidance given by the US central bank (the Federal Reserve, or ‘Fed’) for 2023. These are not promised outcomes, just the Fed’s best current guess about where they will take rates. The black line is the money market’s view expressed in the futures market. There’s roughly a 0.5% difference, with the money market preferring to believe the Fed will not carry through its ‘best guess’ outcome.
Chart 2: US money market expectations on interest rates vs Federal Reserve guidance
Source: Nutmeg, Federal Reserve, Macrobond
We think the Fed will win the ‘argument’ depicted in Chart 2 and be more hawkish (aggressive) than the markets expect, which may cause some adverse market volatility in the short-term.
Overall, though, there is a growing consensus that the Fed – and other central banks – will stop hiking later this year when it becomes clear that inflation has been adequately dealt with. Once central banks have finished their tightening cycles, it’s likely that government bonds with a short and medium duration could kick off a sustainable rally.
Structural factors will also play a role
There are a few factors that may limit the size and scope of a bond rally – or how low yields can fall and how high prices can rise.
One is that the overall supply of government bonds in the market could remain elevated. This would keep a lid on demand, preventing prices from rising too high.
Why would there be an excess supply of bonds in the market?
Well, one reason is because of quantitative tightening. Central banks are selling government bonds in order to normalise their interventions in financial markets, 14 years after the global financial crisis, which instigated a period of quantitative easing and ultra-low interest rates. The Bank of England, for example, is planning to sell £80 billion of government bonds by the end of September.
Another reason would be fiscal policy. On the one hand, rising interest rates and high indebtedness mean that governments are looking to be fiscally responsible. The reaction to Liz Truss’s mini-Budget last year suggested that markets now have a low tolerance for fiscal largesse.
But, on the other hand, governments will still want to fund investment in industry and infrastructure to maintain a competitive edge in an everchanging world. The present situation of excess supply of bonds may be aggravated by the need of governments to issue even more debt to fund such expenditure. Real yields may need to be higher as a result.
Finally, demographic trends are shifting. Baby boomers, who spent much of the past 40 years saving into pensions (which invest in bonds) are now beginning to spend those savings. In order to spend their pension savings, they must sell their holdings, which returns more bonds to the market. The more bonds there are in supply, the lower their price and higher their yield.
What does this mean for investors?
Where does the balance lie between the two forces? While cyclical factors tend to ‘win the day’ and even the year, structural forces ‘win the decade’.
In the near term, we think that cyclical forces will dominate 2023 – we believe that central banks will have the final say when it comes to the start of a potential government bond rally. In the meantime, we prefer corporate bonds (or ‘credit’) because they carry extra yield. This is the premium investors receive for taking on more direct exposure to economic activity.
In December, we increased our exposure to higher-yielding assets like investment grade and high-yield corporate bonds, moving to an overweight position in UK corporate bonds. You can read more about the changes we made here.
Next time, we’ll turn to China and emerging markets. To read our 2023 outlook in full, click here.
Risk warning
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.
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