By Alexander Jones, International Banker
According to research by Edward McQuarrie, a professor emeritus at Santa Clara University, 2022 was the worst year ever for the bond market in the United States since records began. And with nearly 10 months of this year witnessing bond values plummet further, one might expect 2023 to be on course to eclipse that record and decisively extend the worst bear market in history. While this may still transpire, a broad reversal in bond yields since late October against a moderating outlook for the US economy suggests the worst for the bond market may have already come and gone.
Indeed, this year has seen nothing less than a comprehensive rout in the bond market, which reached its nadir in October, as fears that the Federal Reserve (the Fed) would keep interest rates “higher for longer” sent Treasury yields soaring to their highest levels in 16 years. By October 23, the benchmark US 10-year Treasury note yield was trading at just over 5 percent for the first time since July 2007. With prices of longer-dated Treasurys having collapsed by around 40 percent since the onset of the pandemic in early 2020, the losses racked up during this crash have been well over double those observed in 1981, when the 10-year yield spiked to 16 percent.
US fiscal and monetary policies have not exactly helped matters, particularly the government’s insistence on continued liberal spending despite being confronted with a yawning $2-trillion budget deficit (which, when readjusted to account for the failed student-loan forgiveness plan proposed last year, was double that of 2022’s $1-trillion deficit). Funding this spending has required massive amounts of borrowing, with the Fed duly obliging, leading to more than $7 trillion of debt on its books by November. The resultant oversupply of Treasury notes in the market depressed bond values further, sending yields skywards and ultimately inflicting enormous bearish sentiment across bond and stock markets as investors’ risk appetites dwindled amid a high-rate environment that has continued to make borrowing for companies and households prohibitively expensive.
Indeed, the three months to September saw yields soar by a full 1 percent as speculation grew that interest rates would remain elevated well into 2024 to bring down inflation to the Fed’s target of 2 percent. In August, the U.S. Department of the Treasury announced that it would buy up a whopping $1 trillion of bonds in the three months to October, which also sustained investor bearishness over the supply-demand mismatch. “The unsustainability of the fiscal framework is probably the biggest factor in driving this fear of bonds,” Jim Cielinski, chief investment officer for fixed income at Janus Henderson Investors, told the Financial Times (FT) on November 6. “Supply is shifting up at the same time as demand from price-insensitive buyers has dissipated—most noticeably from central banks.”
But with the US economic outlook improving in recent weeks, a decisive reversal in bond yields has materialised, with the 10-year Treasury yield dropping from 5 percent during the final week of October to trade below 4.5 percent by mid-November. Among the most significant supportive economic data was the annual inflation rate for October, which came in below expectations at 3.2 percent, boosting confidence that the inflation rate is now inching steadily towards the Fed’s target of near-2 percent. The 4.9-percent quarter-on-quarter growth rate posted for the third quarter has also tempered fears somewhat, albeit with government deficit spending contributing significantly to this figure. Traders are thus broadly positioning themselves for the end of the Federal Reserve’s cycle of rate hikes.
Does that mean better days for bond investors are now here? Not necessarily, as officials continue to caution against pricing in an imminent rate cut, despite the boost to expectations from the October inflation number. “We need to be patient and resolute, and I wouldn’t take traditional firming off the table…. We need to look holistically at the data,” Susan M. Collins, president of the Federal Reserve Bank of Boston (Boston Fed), told CNBC on November 17. And while the Fed might be finished hiking rates as part of this tightening cycle, current levels may be maintained to bring inflation down further before the higher-for-longer regime is ended. “It’s still too early to call the all-clear on rates and inflation,” Alberto Gallo, chief investment officer and co-founder of Andromeda Capital Management (ACM), explained to Bloomberg. “The Fed might be done hiking, but that doesn’t mean a lot of cuts are coming soon.”
Recent evidence also suggests that investors want additional compensation to take on longer-dated government bonds. Indeed, yields briefly rose towards 4.7 percent following a lacklustre auction of 30-year Treasury bonds on November 9, which saw the Bloomberg Treasury Index post its worst day’s performance in more than six months, further highlighting the market imbalance that has kept prices falling and yields rising. “What the auction result said is that everyone is worried about supply now,” Mark Nash, head of fixed-income alternatives at Jupiter Asset Management, told Bloomberg. “Things are changing in the market in terms of support.”
When assessing the market over the longer term, moreover, some believe this current bracket of higher bond yields represents a “new normal” for financial markets, with elevated interest rates and higher, less stable inflation rates here to stay. According to Brevan Howard Asset Management’s chief US economist, Jason Cummins, for example, low inflation and ultra-low interest rates in the decade following the 2008 Global Financial Crisis (GFC) may end up being outliers, with the “search for yield” amidst this environment forcing investors to accept progressively lower premia for holding longer-dated debt. This capitulation has been compounded by the enormous bond purchases undertaken by the Fed and other central banks for their quantitative-easing (QE) programmes, which exerted further downward pressures on yields, Cummins added.
“In the past, investors expected a Fed ‘put’ with rate cuts from the Federal Reserve whenever threats to growth emerged. With inflation above target, central bankers are unable to smooth shocks to the real economy or financial market ructions. The era of the Fed ‘put’ is over,” Cummins explained in a November 3 piece he wrote for the Financial Times. “No Fed ‘put’ means no zero rates, no promises of low rates in the future, and certainly no QE to rescue investors when they suffer losses…. In retrospect, the new normal looks like a unique period of historically depressed interest rates after the financial crisis. In the future, investors will have to learn anew how to operate without a fiscal or monetary safety net.”
And with long-term forecasts suggesting that the federal budget deficit will continue to deteriorate, soaring US bond yields could be here for some time. Indeed, the Congressional Budget Office (CBO) forecasted that US budget deficits over the next 30 years would easily surpass the average of 3.7 percent of the country’s gross domestic product (GDP) recorded between 1993 and 2022, reaching 6.4 percent in 2033 and 10.0 percent in 2053. The International Monetary Fund (IMF), meanwhile, stated it expects the deficit to exceed 8 percent of GDP this year and net borrowing to remain elevated at 7 percent of GDP in five years.
It should come as no surprise that Moody’s Investors Services announced on November 10 that it had cut its outlook for the US credit rating from stable to negative due to this fiscal mismanagement. Although it remains the only one of the “big three” credit-rating agencies not to have cut the US’ sovereign rating to date (Fitch Ratings announced a downgrade to AA+ from AAA in August, while S&P Global Ratings did so back in 2011), this latest action nonetheless demonstrates Moody’s clear concern over the government’s ability to repay its mounting $33-trillion pile of debt amidst a climate of sharply rising borrowing costs.
Should Moody’s negative outlook be followed by a downgrade, mounting worries over US debt could profoundly impact yields, with the country’s increasingly exposed fiscal and monetary vulnerabilities only further supporting this “new normal” narrative for bond markets. “In the context of higher interest rates, without effective fiscal policy measures to reduce government spending or increase revenues, Moody’s expects that the US’ fiscal deficits will remain very large, significantly weakening debt affordability,” the rating firm noted. Moody’s also pointed to the continued political polarisation within the United States Congress, which “raises the risk that successive governments will not be able to reach consensus on a fiscal plan to slow the decline in debt affordability”.
That said, there is still enough near-term demand in the market to suggest that a decisive reversal in yields is not entirely out of the question going into 2024, particularly if inflation can be contained ahead of schedule. “Longer term, we’re very bullish on Treasuries and the rates market, and we think that they offer really good value,” Jamie Patton, co-head of global rates at Los Angeles-based investment firm TCW Group (with approximately $200 billion under management), told Bloomberg after buying 30-year Treasury bonds at the November 9 auction. “We’ve never, in the history of modern monetary policy, seen the Fed raise rates by over 500 basis points and not had any accident or correction or recession.”