The record-breaking global bond market rally since the start of this year has fizzled out as mounting signs of persistent inflation force investors to reverse their views on the likely future path of interest rate rises.
Investors rushed into fixed income in the first few weeks of 2023 as they became increasingly expectant that the US Federal Reserve and other major central banks would soon end their aggressive campaign of monetary policy tightening.
A Bloomberg index tracking high-grade government and corporate bonds rose as much as 4 per cent last month, its best ever start to the year.
But that gain has now disappeared after a scorching US labour market report earlier this month kicked off a run of better than expected economic data on both sides of the Atlantic, upending expectations that the Fed and the European Central Bank were close to winning their battle with inflation.
The resulting rise in bond yields has also upset a rally in the stock market, with the S&P 500 losing 2.7 per cent in the past week.
“We’ve had a reality check,” said Michael Metcalfe, head of macro strategy at State Street, adding that the easing of monetary policy expected by markets a few weeks ago “looked a little fanciful”.
The biggest reversal has come in the US after data showed that employers added more than half a million jobs in January, nearly triple what economists had forecast, and that consumer price growth stood at 6.4 per cent — also above projections.
On Friday the Fed’s preferred gauge of price growth — core monthly personal consumption expenditure — rose 0.6 per cent from December to January, higher than consensus forecasts.
Futures markets, which had previously reflected bets that the US central bank would reduce interest rates twice later this year, now predict that rates will rise to 5.4 per cent by July, with at most a single cut by the end of the year.
“Early this year, markets got ahead of themselves in terms of pricing in Fed cuts, hoping this cycle would end sooner,” said Idanna Appio, a portfolio manager at First Eagle Investment Management.
“Things were priced for perfection — investors were betting that the Fed was going to get inflation down successfully and quickly. I think this process is going to take longer than people thought.”
In a further reflection of shifting sentiment, bond fund flows have reversed in recent weeks — particularly at the riskier end of the credit spectrum.
Emerging market bonds, which soared in January, this week saw the biggest outflows since October, JPMorgan data show. Globally, more than $7bn has leaked out of “junk” rated corporate bond funds so far in February, according to data from EPFR, after net inflows of $3.9bn in January.
Investors are demanding a higher premium to hold high-yield, low-rated corporate debt than they were last month, when market ebullience diminished concerns about debt defaults.
The gulf between yields on US junk bonds and those of Treasury notes tightened by as much as 0.87 percentage points from New Year’s Eve to reach 3.94 percentage points in mid-January. But that spread has since widened to 4.3 percentage points.
John McClain, portfolio manager at Brandywine Global Investment Management, said rates would stay at a higher level than expected “for the foreseeable future”.
“We don’t anticipate rate cuts in 2023, and so that’s going to eventually lead to stress in the riskier segments of credit,” he said.
The shift in investors’ expectations is an acknowledgement of the Fed’s insistence since the start of the year that rates would remain elevated for a prolonged period. A survey of Fed officials from December showed they expected borrowing costs to end the year at about 5.1 per cent.
Now, some analysts are wondering whether the central bank’s own projections are too conservative.
“There is a real chance that we could go over a 6 per cent rate. If the data continue to show improvement, there is a real chance that the Fed is behind the curve at the moment and that rates have to go up more than expected,” said Calvin Tse, head of Americas macro strategy at BNP Paribas.
Some big investors say the recent sell-off is a sign that it is too soon to pile into bonds; that moment is likely to come later in the year.
“Of course the Fed will at some point cut rates, but the market was trying to pre-empt that . . . and it was so, so premature,” said Sonal Desai, chief investment officer of Franklin Templeton. “I still think it is a very good year for fixed income. I just don’t think we’re there yet.”
