A Bear Market in Bonds
As August moved into September, financial markets experienced the first global bear market in bonds for several decades. There have been defaults in individual countries, devastating losses in housing-related credit from China to the US and restructuring of both companies and countries. But it has been decades since central banks last got monetary policy so wrong that the USD Global Aggregate index lost 20% (an index of government and corporate investment grade bonds). The loss came despite “bond positive” macro numbers, including declining US housing activity and a rollover in house prices, less inflationary pressure reported in the monthly ISM report and a decline in headline inflation and core PCE inflation. In this context, the losses were induced by a continued shift from excessively easy policy in 2021 to renewed central bank talk of the need to tighten policy further and increased risk of excessively tight policy.
The peak of the stress came after the Jackson Hole conference, at which Fed Chair Powell's speech was remarkable for its hawkish tone, its brevity (6 minutes) and its lack of the usual theoretical and empirical underpinning seen at this event in recent years. Even if the Fed Chairman would not admit the FOMC's part in the inflationary disaster they have helped create, it was reasonable to expect that when he finished his speech with “we will keep at it until we are confident the job is done” he would at least have made clear what “the job” is. But as of today, we do not know if he is talking about getting inflation down to 2% within the forecast horizon, or if he means hiking until inflation is in fact this far down. The difference is important, both for financial markets and for the world at large, since it can imply several quarters of additional hiking. In Europe, the ECB is on even thinner ice, because their inflation controlling mandate is clear, but their action
Figure 1. After procrastinating through 2021, the Fed has now forced up the yield curve
has not progressed as far. It is fair to ask why they kept rates at below zero in 2021 when they expected growth above the trend, when employment has continued to grow and inflation continued to accelerate. What is more important is that they are now looking to hike with strong self-serving resolve. This has led to a dramatic sell off in the European bond markets. And as the ECB is hiking into a decelerating economy, balancing on the edge of recession, it has also helped to send peripheral spreads out and thereby worsened the outlook for the weakest economies. On the back of this development, the Euro Aggregate bonds index was down approximately 5% throughout August. Investment grade bond indices declined more than 4% and Euro denominated high yield bonds lost more than 3%. In our view market have more likely than not priced in the full extent of the needed hiking cycle. Still, the lack of clarity around what exactly central banks are targeting makes in uncertain if the hiking will stop in time of it will be overdone as was the case with the easing. In any case, we expect growth will continue to decelerate and that inflation will prove to be more cyclical than expected.
As the Euro area flirts with recession and the US housing market has cooled and yields have increased, a repeat of the large increase in yields and sell off in bonds seen year to date is unlikely. In the context of the slowdown, reflected in credit spread prices; the relative advantage corporates have of inflation reducing real rates and debt levels relative to their selling prices; and the relatively high credit quality in High Yield; we prefer credit over government bonds and within fixed income we therefore remain cautiously positioned in terms of duration, while still holding corporate credit risk across our fixed income mandates and funds. At the same time the balance of risk has led us to maintain our balanced position across our multi asset portfolios. Specifically:
In our dynamic allocation strategies, with up to 100% equities, we hold an equity allocation of 60%-70%, buying primarily US equities.
Across our Global Fixed Income Opportunities portfolios, we are maintaining our holdings of high yield bonds around 60%-70% with our low-risk Sustainable GFO mandates holding 30%-40% high yield bonds.
In our balanced multi-asset strategies, we are maintaining stable equity allocations of between 30% and 50% and in addition making allocations to high yield bonds.
Confusing bank communication into an improving inflation outlook
The world is constantly poised between the positive and negative forces in motion that swing dynamically between improvement and deterioration. On the negative side, both Putin and Xi Jinping have shown extreme self-serving autocratic tendencies. Simultaneously, western central banks have boosted their interest rate hiking ambitions just at a time where their competence seemed to have reached a secular low point. After sleeping at the wheel in 2021 and charging their speeches during the greater part of recent years with benign forecasts and outcomes, the pendulum of consensus of central bankers seems to have swung and they now appear to be trying to save lost prestige by focussing on avoiding a worst-case stagflation scenario similar to the 1970's. But by starting to combat inflation so late, the inflationary pain they have inflicted has ended up being much worse than needed; and indeed, they now seem to be risking the income and asset values of the global working and middle classes in a vain attempt to save their reputation.
The issue with the uncertainty of central banks is well illustrated by Powell’s communications in recent months. At the most recent FOMC meeting, he delivered a dovish message. At the next big event in Jackson Hole, he followed up on a hawkish note. On this latter occasion, which has a very wide audience, he could have recognised responsibilities, clarified the goals of the Fed and laid out a plan for how to bring back price stability and credibility. Instead, he made an ultra-short speech at Jackson Hole (reported to be 6 minutes), which not only did not recognise the causes and effects of monetary policy in recent years but, more importantly, lacked clarity regarding future goals. He stated that the Fed “must keep at it until the job is done” (he made the two almost similar statements) on the same
Figure 2: 10-year GB yields increases have led to the fastest tightening in 20-years
page) but did not clarify such a loose expression. Does it mean the job is done when there is a downward trend in inflation, or when in fact inflation is down?
We are now in a situation in which financial conditions, if measured in a traditional way, such as changes in 10-year government bond yields, have tightened more in the last 12 months than at any time in the previous 20-years. Figure 2 illustrates the 10-year government bond yield moving up across the Eurozone and the US more decisively than any time in the last two decades. This is dramatic and the fact that it is happening in a global economy with unusually high leverage makes it even more of a risky project both for housing markets and for government debt in Italy and Spain.
With central banks being unhelpful, it is as important as ever to look at both traditional drivers of inflation, markets, and the economy. While European gas prices have a story of their own, from our perspective the global picture is improving in as much as inflationary pressure is coming down. One traditional driver of inflation is the money supply. USD M2 growth as shown in Figure 3, for example, has declined further in recent months. This is likely to have the positive effect of dampening inflation and also making monetarists and possibly bond investors less nervous.
Figure 3: US Money Supply has normalised almost as fast as it spiked
There is little evidence that it matters much for inflation if M2 grows 5%, 7% or 9%, but at least with hindsight, it seems that letting it grow by more than 20% was an absurd experiment, that was too risky to take. And as has so often happened before, it is an experiment of which the outcome is much more difficult for the average person and consumer to deal with than for those who conducted the experiment.
With bond yields back up towards previous highs, equity markets saw renewed volatility over recent weeks, which indicates that rate increases were being priced into equity prices. Even so, the relative calm compared to the first half of the year led to a significant upward movement in our market-based algorithms. In recent weeks, this has been followed by a more widespread improvement in macro conditions (see Figure 4 below). While life would be easier if a set of rules or algorithms could always be followed, something truly different such as the situation due to the pandemic must be recognised. For our algorithms, this means that the business cycle trend component of the macro algorithms has
Figure 4: Our algorithms was lifted by business cycle support, but has now turned
been distorted by the abnormal swings in macro data during and after the pandemic recession. We are thus mainly focussing on the improvement in credit conditions, where broadly speaking we have seen sideways movements in recent months compared to the dramatically higher rates in first half of the year, reflected both in the momentum in total returns, which has been less negative than for government bonds, and also in credit spreads. Our credit conditions algorithms have thus moved from the most negative signal of minus 1 to a still negative but improved reading. This is supplemented by a tentative increase in the momentum of US corporate earnings which since October 2021 had been declining steadily from a maximum strength towards a medium reading (close to zero).
Such a development is normally an indication of improved market conditions The reason we have not been increasing our risk allocations is the noise and volatility created by the above-mentioned hawkish stance of central banks, which have given rise to a turnaround in the market component of our algorithms and a stagnation and small decline in the overall algorithms. We would thus need at least equity stability before increasing risk and adding to our positions in equity and high yield markets.
While significant in the short run, the effect of recent noises from the central banks has until now been mild compared to the first half of the year. The risk of a move in yields comparable to the first half, with the associated devastating effects on equity valuations cannot be ruled out, but is now lower. The main reasons are that inflation expectations remain under control, economic growth has decelerated significantly and, in particular, the US housing market has slowed down from its red-hot activity level. An illustration of this effect of tighter monetary policy is the increase in US mortgage rates, seen in Figure 5. Both the 15-year and 30-year rates have increased more in this hiking cycle than at any time in the last 20 years. Housing activity now shows clear signs of cooling off. The significant importance of housing for the US economy, both in the form of economic activity and its effects on wealth, means that a slowdown together with the continued drag from high mortgage rates is likely to make further hikes less acute.
Figure 5: US Mortgage rates have increased more than at any time in the last 20 years
All of the above probably means that the action of the Fed and the markets’ expectations of future tightening is now priced into credit and equity markets and that the negative feedback loop between declining economic activity, higher risk and higher financing costs has been dampened. Normally, the next step is either a new shock (like Lehman in 2008) which would mean that the negative cycle resumes, or a renewed positive cycle starts in which a cooling economy leads to lower borrowing costs which help to improve financial conditions and thereby lay the foundation for future profits. This is often the way in which a recession or a slowdown ends and the pattern that markets follow when transitioning into a renewed recovery. On the assumption that central banks will not overtighten, this is also what we expect this time around. If confirmed by markets in the coming days and weeks, we are likely to get a more solid buy signal from our algorithms and will thus increase our allocation to high yield bonds and equities. As always, we will keep our clients and partners well posted on any such move.
Figure 6: Inflation year on year has peaked in the US
Mads N. S. Pedersen
Managing Partner and CIO