Market Perspectives September 2023
Read our latest round-up of the global themes, trends and events currently influencing investors.
Fixed income
04 September 2023
Michel Vernier, CFA, London UK, Head of Fixed Income Strategy
Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.
Since late July, the surge in global rates has reaccelerated. This time, the gravitational pull was felt at the long end of the rate curve, as opposed to the short end, which has led to the overall repricing of rate curves during this rate-hiking cycle.
The long end in the US has been pressured by supply-and-demand concerns. Three main factors came into play here: first, the US downgrade by rating agency Fitch from AAA to AA+. Investors have been sensitised to the fact that even one of the more, if not the most, important issuers is not protected against a rating downgrade.
However, the main reason of the downgrade was not the lack of ability to pay the debt, but rather a warning to politicians that the debt ceiling should not be used as a playing field to push agendas which come at a cost of compromising the US’ credibility as an issuer.
The second factor underpinning higher US yields came from the Bank of Japan’s intention to be more flexible on its approach to yields, which could potentially lead to less US bond buying. This seems more theoretical in nature at this point.
The third factor was the prospect of higher issue sizes by the US Treasury in the coming quarters.
The pull from the long end was felt through higher absolute yields, and the part reversal of the deep inversion in the US curve (with the 2-year yield higher than the 10-year yield) from less than -100 basis points (bp) to roughly -70bp between late July and late August. Indeed, the net supply of bonds via higher government issuance should not be neglected, but it seems unlikely that these factors will drive rates over the long run.
History shows that a country’s budget deficits and debt are weakly correlated with higher yields, especially for higher-rated issuers. The main focus for investors is likely to remain the inflation outlook, and the response of the respective central banks to it, traditionally the main driver for yield trends. Eyes are likely to be more focused in this direction than usual, with the bond market seemingly transitioning into the late stage of the rate-hiking cycle.
Certainly, the possibility remains that central banks this time hold rates higher for longer, mainly because of persistent higher core inflation (which excludes volatile energy and food price components from the index). Still, there remains the danger of central bankers being complacent in their fight against the pace of price rises. That said, higher rates are therefore unlikely to remain forever.
Bond markets in the late stage of a cycle of cash, bonds and investment-grade corporate bonds during a hiking cycle, were explored in more detail in the article When the race is on during cycles.
The article shows that corporate bonds (based on index performance of a respective US investment grade index with roughly a six-year duration) outperformed cash once rates peaked. During the last nine hiking cycles, this outperformance averaged 12% in the following two-year period. In other words, investors keeping funds in higher cash rates initially, would soon be re-investing into significantly lower rates. Meanwhile, returns on bond portfolios were lifted by lower market rates.
At times of unusually elevated inflation, bond investors rightly ask whether higher nominal yields are the real deal or not. Ultimately, inflation-adjusted returns are most relevant for investments aimed at protecting wealth.
In this context, do higher nominal yields lead to higher real returns? The most obvious measure in this context seems to be the real yield, the nominal yield adjusted for inflation. The good news is that real yields have surged in recent months, along with nominal yields. In the US they are the highest they’ve been since 2008 (see chart).
Real policy rates in the US, eurozone and UK have risen for over a year. Indeed, the real rate for the first-named is back to pre-global financial crisis levels
Are real yields attractive and can an adequate level of real yields be defined? One option might be to use the equilibrium real yield, as used by central banks. This is the real yield at which an economy grows at potential, while at full employment and without pushing inflation substantially higher or lower. In other words, a yield that is just the right temperature and one that central bankers ultimately aspire to.
This theoretical neutral real rate level changes, being dependent on the economic environment. Factors like population growth, global bond flows and productivity growth influence the rate.
In reality, the neutral real yield (named “r-star” by central bankers) has trended substantially lower over recent decades. The US Federal Reserve (Fed) currently expects this long-time rate to trend towards 0.5%, in its own projections. That said, even within the Fed, the adequate level is debated: a recent Federal Reserve Bank of New York (New York Fed) paper puts the neutral real yield at between 0.75% to even 1.8%, depending on the model used, such as the Laubach-Williams model1.
For bond investors, however, the real policy rate as illustrated above may not be applicable for two reasons. First, the short-term central bank rate may not reflect the term of a bond investment. Second, and most importantly, it is the anticipated inflation that matters most for future real returns. Given the high level of uncertainty over prospective inflation, it is clear that a guaranteed real yield can hardly be achieved when investing in nominal bonds.
In order to assess whether a real yield provides reasonable returns, after inflation, a perfect and adverse scenario might help. A perfect scenario could be thought of as one where investors lock in a high real rate over a 12-month period, with inflation falling substantially during the holding period. By contrast, an adverse scenario could be one that is characterised by a low, or even negative, real rate, with inflation rising over the subsequent holding period.
In this context, rather than the actual real yield, it is the outlook for inflation that matters. After rates peak, it is common for inflation to subside. After all, it is the job of central banks to hike until inflation is clearly in retreat, without overdoing it and driving the economy into a recession.
After substantial hikes by leading central banks, US, eurozone and the UK inflation is in retreat. In the US, after a 5.25-point surge in hikes since February 20222, the late phase of the hiking cycle appears to be here (see chart).
US policy is in a state of flux. The policy rate, known as the fed funds rate, is back to pre-global financial crisis levels, while the country’s core inflation rate has just hit levels last seen in the 1980s
Meanwhile, core inflation has already moderated by two points in the last 10 months, from its peak at 6.7%. The Fed, along with the broader market expectations, according to Bloomberg, anticipates that core inflation will moderate towards 2.2% by 2025.
The main uncertainty, at this point, revolves around the timing and magnitude of anticipated softening in inflation. Despite the timing uncertainty, today could potentially represent an optimal foundation for attractive real bond returns.
The period after the US inflation peak seen in the early 1980s shows that real rates are often a result of anchoring people’s expectations over price rises. Investors usually want higher yields to compensate for future inflation. The nominal yield demanded tends to be a result of the most recent inflation levels. In the 1980s, investors enjoyed high yields, given the expectation that inflation could remain elevated for longer. Consequently, the subsequent retreat of inflation provided relatively attractive real returns.
Since the early 1990s, actual, rather than proxy, real rates can be obtained from inflation-linked bonds. In the US, 5-year real yields trade at around 2.2%, much higher than the 0.5% rate projected by the Fed or in a recent study by the New York Fed, which calculates 5-year term neutral rates at around 1% or lower.
Real rates in isolation do not necessarily provide much of a guide as to future real returns for nominal bonds (real yields can only by locked in via inflation-linked bonds). Eras of relatively high nominal yields and elevated inflation, however, provide a good foundation for reasonable real returns.
Read our latest round-up of the global themes, trends and events currently influencing investors.
This communication is general in nature and provided for information/educational purposes only. It does not take into account any specific investment objectives, the financial situation or particular needs of any particular person. It not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful for them to access.
This communication has been prepared by Barclays Private Bank (Barclays) and references to Barclays includes any entity within the Barclays group of companies.
This communication:
(i) is not research nor a product of the Barclays Research department. Any views expressed in these materials may differ from those of the Barclays Research department. All opinions and estimates are given as of the date of the materials and are subject to change. Barclays is not obliged to inform recipients of these materials of any change to such opinions or estimates;
(ii) is not an offer, an invitation or a recommendation to enter into any product or service and does not constitute a solicitation to buy or sell securities, investment advice or a personal recommendation;
(iii) is confidential and no part may be reproduced, distributed or transmitted without the prior written permission of Barclays; and
(iv) has not been reviewed or approved by any regulatory authority.
Any past or simulated past performance including back-testing, modelling or scenario analysis, or future projections contained in this communication is no indication as to future performance. No representation is made as to the accuracy of the assumptions made in this communication, or completeness of, any modelling, scenario analysis or back-testing. The value of any investment may also fluctuate as a result of market changes.
Where information in this communication has been obtained from third party sources, we believe those sources to be reliable but we do not guarantee the information’s accuracy and you should note that it may be incomplete or condensed.
Neither Barclays nor any of its directors, officers, employees, representatives or agents, accepts any liability whatsoever for any direct, indirect or consequential losses (in contract, tort or otherwise) arising from the use of this communication or its contents or reliance on the information contained herein, except to the extent this would be prohibited by law or regulation.