With inflation down from multi-decade highs, monetary policymakers have delicate trade-offs to make as they plot their next steps. Steve Ryder and Daniel Bright assess the possible outcomes and implications for sovereign debt investors.
Read this article to understand:
- How central banks are weighing up if eradicating inflation will prove too costly
- How sovereign issuers are being impacted as debt rolls over in a higher rates world
- Opportunities for investors as prospects diverge and term premia increase.
Uncertainty over inflation and growth continue to weigh on the fixed-income market. While sovereign bond investors have greater income protection than before, navigating the market remains complex. The key questions include: what level of inflation will central banks be comfortable with to stop rate hikes; when and where will rates peak and what happens after that?
Trying to get a grip on these questions is occupying the thoughts of sovereign investors, whose universe is expected to swell to a record $65 trillion in 2023.1 While the potential for higher returns is greater, so are the vulnerabilities if rates remain higher for longer.
To get a sense of the opportunities and challenges as policymakers feel their way towards a post-pandemic "normal" state, we put the questions to Steve Ryder (SR), senior portfolio manager, global rates, and portfolio manager Daniel Bright (DB).
How would you assess current conditions in sovereign bond markets?
SR: In the first half, bond markets were driven by the ongoing repricing of central bank policy expectations. This was interrupted by the fallout from the US banking crisis, which saw yields move higher and curves re-flatten as markets priced in further policy tightening.
Despite this, our global bond benchmark still returned 1.84 per cent returns in the first half. This is in stark contrast to last year’s negative returns and aligns with our base case for the year: that the index would deliver its yield (around three per cent) as the income available in government bonds would help offset capital losses.
The dynamic has changed since July, particularly in the US. The market is more comfortable with peak policy rates and there is more focus on growth and whether the neutral policy rate will be much higher. This has led to the sell-off being driven by more intermediate maturity bonds and the yield curve “bear steepening”.
This has happened alongside a further adjustment to the Japanese yield curve control (YCC) policy and increase in US Treasury supply. While this is a challenge to our outlook, we maintain the view growth will moderate over the coming quarters.
How have the Bank of Japan’s adjustments to YCC impacted the market?
DB: At the end of July, the Bank of Japan (BoJ) raised its cap on ten-year yields from 0.5 per cent to one per cent as a hard limit, but it may be willing to intervene anywhere in that zone.
The increase in the cap is a necessary first step towards what might eventually be the removal of more accommodative policy and it reduces quantitative easing (QE) associated with YCC.
The move has reduced global liquidity and adds further impetus to higher yields in other markets. Without the BoJ as an enthusiastic buyer of Japanese government bonds (JGBs), the yield can rise to whatever the market deems an equilibrium level. Higher JGB yields increase the attractiveness for domestic and foreign buyers because the FX-hedged yield is attractive internationally. That might come at the expense of other developed market sovereign bonds.
Ten-year Japanese bond yields are around 0.7 per cent. We remain underweight Japanese government bonds; however, we believe the yield will only grind higher gradually and see pent up demand from those who have been waiting for the policy change.
How are term premia changing?
SR: When we last spoke (Global sovereign bonds: Are peak rates in sight?), we outlined that as central banks delivered their final hikes and switched to a more data-dependent stance, we would start to see a rebuild of term premia in sovereign bond curves.
By moving to a wait-and-see approach on rates when inflation is still too high, policymakers have introduced that uncertainty. That’s not to say this is wrong – it is appropriate to be patient given the long and uncertain lags with which monetary policy impacts the economy. Nevertheless, ongoing inflation uncertainty should command a risk premium in bonds as the distribution of scenarios widens.
There are many ways to measure term premia. Simplistically, it is the risk premium for bonds investors demand over and above the path of expected policy rates. While we believe this should increase, the rate of change is also important. The magnitude and speed of the move over the last few weeks has surprised us; it’s likely to be a function of many things happening at once during the summer months, but it is in keeping with our view that yield curves are likely to steepen.
In our view, investors are now being compensated more adequately for duration risk. While the growth and inflation outlook are still uncertain, we see value in duration in the medium term, with US ten-year real yields now around two per cent. These are levels not seen since before the Global Financial Crisis, and above estimates of the long-term neutral rate of the US economy.
Attention has shifted from how high rates might be at the peak to realising they are likely to stay higher for longer. What are the implications?
SR: Our base case remains we are at or close to the end of the tightening cycle in most major markets. Central banks are now set on maintaining rates at restrictive levels while they assess the impact of the cumulative tightening of policy and the inflation outlook.
The higher-for-longer environment has already had a material impact, significantly impacting yields over the last two months. While uncertainty around growth and inflation remain, we expect a period of on-hold policy will eventually be followed by policy easing.
Most developed markets rates still price in a level of tightening over the next few months and, apart from the US, maintain little in the way of easing over the next year. It’s the US where there is still a case for rate cuts to be pushed out further, although this has also seen significant repricing over the recent weeks.
DB: We have been underweight the front end of the US yield curve for some time. The cuts priced in are larger than in other countries, while simultaneously many aspects of the US economy are less sensitive to interest rates. In the US housing market, for instance, it is common to have your mortgage rate fixed for 30 years. In the UK, on the other hand, two or five-year fixed terms are the norm. Moreover, because the US curve is inverted, if you are underweight the US in the front end and nothing happens, you make money by rolling up the curve. It’s an attractive place where you are rewarded if you are short.
While the US might be ahead of other nations in its tightening cycle, it doesn't feel right to have so many cuts priced in there and so few elsewhere, for example in Europe, the UK or Australia. When we have had overweight duration positions in other geographies, we have often used a US underweight to counterbalance them. But because we have had a view we are moving towards the end of the cycle, we have been overweight duration more generally.
The US Treasury/Bund spread has widened sharply since April. Why?
SR: It's a function of two things. First, the scaling back of expectations for US rate cuts post the US banking crisis, and a series of much stronger growth data.
The second issue is softer data in Europe. While the European Central Bank (ECB) was initially slower to raise rates than other central banks, it has played catch-up since the start of the year. But over the summer, we have started to see weaker inflation and survey data, and the ECB has started to move towards a more balanced policy view. The US-Europe bond spread has predominantly been driven by rate expectations for terminal and neutral rates and diverging economic outlooks rather than deficit concerns.
Figure 1 shows the size of the divergence in economic data surprises since May: the magnitude of US economic “beats” relative to EU “misses” has hit some of the most extreme levels in the last 20 years. Figure 2 depicts this more clearly, showing how the gap between the US and the euro zone on an economic surprise index has risen sharply in recent months.
Figure 1: US and Europe: Economic surprises (index)
Source: Aviva Investors, Bloomberg. Data as of August 30, 2023.
Figure 2: Gap between US and Eurozone Citi Economic Surprise Indices (index spread)
Source: Aviva Investors, Bloomberg. Data as of August 30, 2023.
What conditions are needed for central banks to begin easing policy?
SR: Central banks will ease policy on growth concerns or if a recession emerges. The more uncertain scenario is around inflation falling while growth is fair. That’s when the trade-off becomes much more difficult: will resilient growth contribute to resurgent inflation down the road?
As inflation falls over the next few quarters, the real policy rate will become more restrictive. At this point, we believe central banks will become increasingly concerned about over-tightening. If the economy has managed a soft landing, the sensitivity to any growth weakness will increase and we believe policy will be eased. This is likely to be gradual initially as central banks continue with a data-dependent, wait-and-see approach. And there are clearly risks from being too aggressive and sending the economy into a deeper slowdown to factor in too.
DB: In terms of whether central banks may be more accepting of inflation in future, this opens fundamental questions around the policy framework. Is a two per cent inflation target appropriate? Why not three, or four? Perhaps there should be a switch to nominal GDP targeting, or something else? We don’t have a strong view on the answers but believe the Federal Reserve and other central banks won’t engage in that discussion until inflation is more firmly under control.
Are you seeing any significant impact from rising debt interest costs?
DB: The cost to issuers for new debt is significantly higher than average interest rates on the stock of total debt. As low-yielding debt is rolled over and replaced by more costly issues, the effective interest rate increases, and more taxpayers’ money is spent servicing the debt rather than on more productive uses.
There's another angle here with quantitative tightening (QT) that makes the pass-through faster. When a central bank undergoes QT, it sells government bonds it bought during QE. This increases the net supply of bonds and reduces excess liquidity, as banks and investors hand over cash or reserves in return for the bond. It has always been difficult to prove the exact effects of QE and QT, but higher net supply could increase term premia, yields and improve market functioning.
However, central banks bought these bonds when yields were low (and bond prices high), and now they are selling when yields are high (and bond prices low). How do they fund it? In the UK, for example, the Treasury indemnifies the Bank of England (BoE) against losses from QT.
This means that when the Bank crystallises a loss on a bond sale, there is a transfer from the Treasury to the Bank. QT therefore accelerates the increase in average interest rates, as the government needs to fund that cash transfer somehow and it will likely be funded by bond issuance (rather than higher taxes).
But it is worth remembering governments benefited from the other side of the equation in the previous decade when yields fell. The BoE estimates that between 2013 and September 2022, £124 billion was transferred to HMT. The current phase of QT simply reverses that.2
Looking ahead, if growth deteriorates and we have a hard landing, how much can governments use fiscal policy to ease the shock? That’s unclear. In the UK, for instance, there’s been recognition inflation is stickier, but bond buyers have also become more reluctant to step in. This has not been an issue over the past 15 years. Now there is a real question for some countries about how much longer governments can run with persistent, high budget deficits without fiscal retrenchment.
SR: There is a question too around the point when central banks might start to ease rates for financial stability reasons. Last year, the BoE had to act during the budget and liability-driven investment (LDI) crisis, acting as a purchaser-of-last-resort by restarting QE even with inflation elevated. The ECB also announced a Transmission Protection Instrument (TPI) to ensure an orderly transition away from QE and to ensure monetary policy is effective. This year, we also saw measures from the Fed after issues arose at Silicon Valley Bank to shore up the market.
There is a broader issue related to debt overhang, which is predominantly on government balance sheets. Before 2008, a lot of debt was loaded on household and corporate balance sheets; while they have been deleveraging, governments have taken debt on, and now there's an ongoing need to fund it. We believe there is enough demand to meet the increase in supply, but demand is more price sensitive. Investors will need comfort on the growth/inflation backdrop and impact on monetary policy.
US economist Kenneth Rogoff suggested it was “a minor miracle” there was no systemic financial crisis in 2022. Do you expect more aftershocks from the interest rate regime change?
DB: It is absolutely a minor miracle. We narrowly avoided one with the LDI crisis. This year we have had a banking crisis in the US that did not become systemic, but there were valid fears it could have been without swift action by central banks.
Now we have had several months of more resilient economic data than expected, markets have begun to extrapolate that into the future, prompting this higher-for-longer narrative. The consensus is that we are facing a soft landing, where inflation subsides but growth will be adequate. It’s a plausible scenario, but there's not much priced in to compensate investors should the outlook deteriorate significantly. That’s also a valid risk, given the pace of the hiking cycle.
SR: A lot has been made of the equity/bond correlation and how bonds are not necessarily giving investors the protection they require. Nevertheless, in a risk-off environment, you can see cash holders turning back to bond markets for safe havens, and those havens now have much better yields. That's why we see value in bond markets in the medium term.
The longer rates stay elevated, the more chance we have of another crisis. No one was talking about the stability of small, regional US banks at the start of the year. We know other pockets of stress will appear, because higher-for-longer increases the risk of something going wrong.
