By Matthias Busuttil
After experiencing a tumultuous year in 2021 in bond markets, investors started 2022 on a weak footing, feeling the pinch of a rapid decline in bond prices primarily because of a sharp increase in benchmark bond yields. Since the start of the year, the US 10-year treasury yield rose from 1.51% to 1.99% and the German 10-year bund yield rose from -0.18% to 0.24%.
The US bond market has been the main market to watch given that the debate around the high levels of inflation and expectations on central bank policy is more intense. Moreover, market developments in this region tends to influence market pricing in other advanced economies.
The expectation that central banks will start raising policy rates has been clear for some time now. Central bankers have communicated incessantly that they are eyeing the progress of the economic recovery, particularly the ability to restore employment, and inflation developments to initiate a gradual normalisation of policy rates and end, or reverse, quantitative easing programmes. With this in mind, market participants have been scrutinising economic data releases to assess the probability and extent of such policy actions.
Throughout 2021, bond markets have been pricing in the expectation of a rate hiking trajectory. However, what really exacerbated the move higher in yields in 2022 has been the upside surprises in inflation data, particularly the January readings which pushed US headline rates to 7.5% and the Euro Area to 5.1%. Still, these higher readings did not result in higher inflation premia in bond yields per se, but it led to higher expectations of a more aggressive response by central banks.
As can be seen in the first chart, the US rate market is pricing in a much faster pace of rate hikes compared to consensus economic forecasts. Therefore, recent movements in yields seem to overestimate the central bank policy response at the front-end compared to what should be reasonably expected in the current economic conditions and inflation expectations.
Moreover, compared to previous rate hiking cycles, the move higher in bond yields in anticipation of policy rate increases has been the most aggressive one yet. In fact, the movement in yields reached four times the average standard deviation in bond yields.
What is also notable is that, at the back-end of the rate hiking cycle, the market is pricing in a terminal policy rate of around 1.70% which is lower than consensus estimates and the Fed’s own long run projection of 2.50%. This differential may either be the market expectation that the Fed will halt rate increases at an earlier point or that the market is yet to price-in a higher terminal rate with the announcement of rate hikes.
Referring to the second chart, what we can also observe from the past rate hiking cycles is that 10-year treasury yields generally declined from recent highs several weeks before the rate hike announcements. This is broadly explained by the sequentially higher expectations of an economic slowdown, or recession, induced by higher policy rates. Again, the recent sharp movement in yields shows that yields have continued to trail higher much closer to the first expected rate increase at the upcoming Fed meeting on 15th March. This is likely the product of the high uncertainty around inflation data as the market awaits an updated assessment and interpretation of these developments by the central bank.
My advice to bond investors is to hang in there and keep calm. Remain cautious, but reacting now can be very costly since the repricing in the market has been excessive. We are most likely past the peak of rate hike expectations and volatility in yields. The volatility in bond prices so far has most likely been the worst you can expect for the rest of the year as we move into the rate hiking cycle by central banks.
There are options to navigate bond portfolios during a period of normalising monetary policy and rising policy rates. For those that maintained a high cash allocation, and therefore an underweight exposure to bonds in anticipation of rate hikes, should consider supplementing their bond positions with floating rate notes which allows them to earn an incrementally higher coupon in line with the rise in short-term rates.
The preference at this stage would be to maintain an overall short duration position, or a short maturity profile on average across the bond portfolio, with the view of incrementally adding back duration and longer-dated positions further down the line.
Corporate bonds can still offer value at current levels on a selective basis, particularly when considering the recent widening in credit spreads (the difference in yields on corporate bonds and the yields on government bonds). Certain sectors in the investment-grade corporate bond markets can offer a relatively more attractive level of yield. High yield corporate bond markets remain a good source for a pick-up in yield with a much shorter duration as compensation for the step-down in credit quality. Despite the expectations of a reduction in monetary stimulus, corporate credit should remain supported by the improving macroeconomic backdrop and the generally positive credit trends on the back of improving operational results by bond issuers.
Source: Bloomberg, Curmi & Partners
Source: Bloomberg, Curmi & Partners
Disclaimer
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.