Start of churn-and-earn bull market for bonds
Fixed-income assets remain at a strategic buy point, even though some consolidation in the near term may occur
FOR those who doubted whether a bull market in bonds was under way, the Federal Reserve’s pivot and the bond market’s fourth quarter turnaround should have laid those doubts to rest. Long-term rates in Western bond markets appear to have passed their peak for the cycle, with the vault to new cycle highs in October 2023 marking the end of the bond bear market. What’s next?
As we suggested a year ago, once yields reach respectable levels, which they did and where they remain, bonds will “churn and earn”. There will be quarter-to-quarter volatility, but over the decade to come, long-term fixed income investors should see these elevated yields manifest as elevated returns.
In short, we remain at a strategic buy point for bonds.
Near term, however, some consolidation or reversal of the recent drop in rates may be in order. Given the recent market pricing of aggressive rate cuts over the next 12 to 24 months – 200 basis points or so in both the US and eurozone – markets will be vulnerable to any higher-than-expected growth or inflation readings.
Similarly, credit spreads tightened dramatically as 2023 came to a close, leaving the potential for spread widening early in 2024 as the market digests its gains. Heavy government and corporate issuance may initially weigh on the market. But as central banks move towards rate cuts over the course of the year, the market’s technical backdrop should improve.
Additionally, the bear market in bond valuations and outflows has reduced bond allocations, while rising equity prices have boosted equity allocations.
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In short, once central banks begin to cut rates, the stage may be set for the mother of all asset allocation trades if investors seek to normalise their portfolio mix by shifting from both stocks and cash into bonds.
Big-picture reflections
The Bank of Japan is widely expected to end its negative-rate policy in early 2024, closing a dark chapter for global bond investors and economies – a period when, ironically, policymakers burned the money of savers and investors in the hopes of boosting economic sentiment and thereby encouraging consumption and investment.
In future crises, will central bankers stop their policy easing at zero, thereby avoiding the unintended destructive side effects of negative rates?
In Europe, after flouting its self-imposed fiscal rules, the eurozone experiment fell on hard times a decade ago. In response to Greece’s default, governments tightened fiscal policy pro-cyclically, creating a grinding headwind for their floundering economies. While we doubted the predictions of a eurozone breakup, we nonetheless envisioned a prolonged stretch of subpar growth that would require an extended period of ultra-low rates and monetary accommodation.
Fast-forward to the first quarter of 2024: The European Central Bank’s cash rate is up to 4 per cent. The Europeans have just remodelled their fiscal rules – the so-called Stability and Growth Pact – to increase flexibility in an effort to maintain fiscal discipline over the long run, but without the unrealistic standards and pro-cyclical mechanisms of the original pact.
Is the current system perfect? By no means, but the bloc’s monetary and fiscal policies have come a long way with the creation of structures designed to mitigate the downside risks that materialised between 2009 and 2012.
Bond benefits, despite inverted yield curve
For now, with cash rates still high, the question lingers for many investors: With the persistence of flat to inverted yield curves and market volatility, why bother with bonds at all?
Just like the year past, the fixed income market continues to offer opportunities in all areas to add value through active management, including term structure positioning, sector allocation, local EM rates, and foreign exchange. Despite the fourth-quarter’s compression in credit spreads, exposure to credit beta should continue adding value as central banks shift towards easing policy rates.
If the past is prologue, one day investors will wake up to find that an unexpected shock has forced central banks to cut rates to zero, bringing to mind the adage when central bank rates rested at the lower bound that “cash is trash”. In that event, investors who failed to lock in higher rates would lose out in the long run.
Furthermore, in a risk-off event – such as the Silicon Valley Bank crisis in the spring of 2023 – government yields may fall, providing ballast to a portfolio’s total return potential. Following central banks’ post-pandemic rate-hiking cycles, long-term yields are attractive. Bonds have revalued.
On the other hand, equity valuation measures, such as price-earnings multiples, appear somewhat stretched. With valuations comparatively extended, stocks may be vulnerable to a repricing due to an economic slowdown or an increase in interest rates.
In sum, with Western central bank cash rates cresting, the fixed income bull market is under way. While a rest may be in order following the fourth quarter’s sharp rally, long-term expected returns appear strong, supported by respectable yields and the range of opportunities to add value through active management.
The writer is chief investment strategist and head of global bonds, PGIM Fixed Income
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