What’s driving this bonds bounce?

US markets have given up on the idea the Fed will cut interest rates by 100 basis points through 2024. Picture: Getty Images

The second half of this year is proving challenging for government bond markets. For example, the yield on the 10-tear government bond in the US is up around 60 basis points since the beginning of July. This is despite the fact that most central banks have signalled that they are close to the end of their tightening cycles in recent months. So what is going on?

At any time, there can be a number of factors driving bond markets. These factors often tend to relate to the monetary policy outlook, the economic outlook, or sometimes, technical factors.

At the moment, we think all three are in play. On the policy outlook, there have been two key developments. First, bond markets have had to rethink the outlook for short-term interest rates as central banks have signalled a “higher for longer” narrative. Effectively, central banks have been telling the market that while it is possible that the tightening cycle is over, expectations of near-term rate cuts are misguided.

In the US, this has forced a repricing of the interest rate outlook as the market has had to give up on the idea that the Federal Reserve would be cutting interest rates by 100 basis points through 2024. Movements in short-term interest rates tend to be an important influence on long-term interest rates, and hence government bond yields have moved higher as the market has absorbed this message.

The second development has been the ongoing resilience of the US economy to higher rates. Not only has this forced economists to lift their expectations for economic growth in the US in 2023, but it has also fuelled some expectation that the Fed will lift its forecast of the long-run neutral rate of interest in coming quarters.

JBWere chief investment officer Sally Auld. Picture: Ryan Osland

The neutral rate of interest is the rate at which monetary policy neither acts as a headwind nor a support to the economy. It is a theoretical concept that central banks use to help them determine their stance on monetary policy – if the policy rate is a long way above the neutral rate, then the stance of monetary policy is likely to be quite restrictive. Another way to think about the neutral rate is that it is the policy rate at which the cash rate averages over the course of the cycle. So, it makes sense to say that if the neutral rate forecasts moves higher, then so will the average policy rate. All else equal, this would see longer-term yields rise too.

Another development that has pushed yields higher has been a shift in the supply and demand dynamic for government bonds, particularly in the US. Demand dynamics relate to changes in the mix of end-buyers of government bonds, particularly those who tend to be more price-insensitive. For example, the Fed is no longer buying US Treasuries, but rather, actively adding to duration supply in the market as it continues to pursue quantitative tightening. Commercial banks and (official) foreign investors – who need to hold a certain part of their portfolios in US Treasuries and thus tend to have relatively price-insensitive demand – have also reduced holdings in recent years. Simultaneously, the US fiscal situation has deteriorated by more than most economists anticipated, meaning that the government will need to issue more debt in the coming months and years relative to market expectations.

As noted above, there are many influences on government bond yields at any point in the economic cycle. Presently, it appears that a number of these influences are all working in the same direction, pushing government bond yields higher. When we take a long-term perspective on the level of government bond yields, we observe that the market has now largely repriced such that yields are back to pre-GFC levels. The post-GFC era of “low for long” interest rates appears to be well and truly over.

This repricing is likely to have significant implications for asset prices and the real economy. The level of interest rates is fundamental to many aspects of household and corporate behaviour, as it influences the decision to save, consume or invest. It would be a brave investor who believes that such a significant and rapid repricing of funding costs has already been seamlessly absorbed by the real economy. Although the recent move in yields presents a challenge for investors who have added exposure to long-duration positions in their multi-asset portfolios, the self-correcting nature of economies and markets – together with central banks’ desire to engineer slower economic growth – will mean that duration exposures will eventually be additive to portfolio returns.

Although we must always remain alert to the possibility of structural changes that might highlight the risk that economies and financial markets don’t behave in line with historical experience, the fundamental impor­tance of interest rates to asset prices and economic decision-making is in the end simply a relationship dictated by the mathematics of finance. It is thus hard to argue that the old rules don’t apply this time around.

Sally Auld is the chief investment officer at JBWere