The bond market has gone up in flames after a decade of falling yields reversed in a matter of weeks. Starting with low yields, tight spreads and high equity multiples, changing fundamentals — particularly high inflation — led to a wholesale repricing of the markets. As a result, bond and equity returns in the year’s first half were the worst since the 1970s, when inflation and uncertainty were similarly high. The mythology surrounding the “phoenix” suggests a renaissance of the bond market, but this would be too early.
For many developed markets (DM) economies, the peak growth rates achieved this year, and the rapid rise in inflation far exceeds anything seen in the past 30 years. In addition, strong job growth and high inflation triggered a major reassessment of market levels in the first quarter that continued through May.
Most DM bond markets have already priced in substantial rate hikes. Broadly speaking, this would be a natural point for yields to go range-bound and wait for either central banks to catch up with the curve or for compelling evidence of a change in the outlook that would require new interest rates.
Although similar paths of rising market interest rates in response to elevated inflation and central bank tightening have been the norm in both developed and emerging markets, there have been two important exceptions.
The Bank of Japan is holding up
First, the Bank of Japan (BoJ) sees the current cycle’s high levels of growth and inflation in Japan as an opportunity to bring actual inflation and inflation expectations closer to its target once and for all. In this effort, it has waged an incredible battle against the global tide of rising interest rates to maintain its +/– 25 basis point trading range on the 10-year Japanese government bond (JGB), which has become a de facto defence of a 25 basis point yield ceiling. Ongoing salvos in this battle included unlimited offers to buy 10-year JGBs at 25 basis points (bps) and ad hoc purchases at all points on the yield curve inconsistent with a 25 bps 10-year bond yield.
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The yen slid as the yield spread between Japan and other markets widened. Although circumstances may dictate a different outcome, the BoJ is likely to continue on this path until the end of central bank chief Haruhiko Kuroda’s term. After that, the short-term interest rate could be guided slightly out of the negative territory and the range for the 10-year yield adjusted to a higher but double-digit basis-point level.
China is providing diversification
The size of the Chinese economy, along with its unique mixed model of market forces and central government policies, has brought something rare to the global investment scene: A potential source of diversification. Since the first quarter, Chinese stocks have diverged from global trends, while Chinese bonds have more or less bucked the global bear market trend over the past year and a half.
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In a world where high correlations between bond and equity markets are the norm, China may be a unique economy with a special policy and size that leads to business and market cycles that are not fully correlated with the rest of the world. Over the long-term, this should create cross-country relative appreciation opportunities while dampening overall market volatility, provided Chinese markets continue to grow rapidly, and cross-country correlation remains low.
Will we see a bond rebirth?
With years of returns wiped out, real yields still extremely low, and credit markets under threat of a hard landing, it doesn’t take much to inspire a bit of despair about the state of the bond market. Admittedly, there is no telling when the current phase will end.
In the medium- to longer-term, however, despair may be the wrong reaction. Could the current sell-off in rates and spreads turn out to be a positive, like a mini 1980s reset? As unlikely as that may seem at present, the fact is that the overarching trends of demographic ageing, high debt burdens, and other factors that pushed equilibrium interest rates down for decades are more likely to hibernate than to reverse.
And if they were to make a comeback after the reopening enthusiasm and supply chain issues pass, inflation would likely be back at — or perhaps even below — target levels. At the same time, bonds would be well on their way to a prolonged period of returns. But before that happy ending can occur, we must get past the end of the Russian gas saga and the bulk of the DM central bank rate hikes. The best approach for the interim will be to focus on micro alpha opportunities within and across sectors.
Robert Tipp is a chief investment strategist and head of global bonds at PGIM Fixed Income
