Follow the curves
I can’t be too bearish on bonds because I can’t see real yields rising enough to push nominal bond yields well above the highs they have reached this year. Certainly not with countries edging back towards lockdowns. Much higher yields would only come if inflation was so persistent that central bankers decided they needed to really squash it. Only then would real yields rise enough to cause huge damage to bond and equity returns. The next six months will be “make or break” for both the pandemic and inflation.
This week the UK government announced measures that tip the country slightly back in the direction of lockdown in response to the threat posed by high existing levels of COVID-19 infections due to the Delta variant and the, as yet, unknown risk coming from the more virulent Omicron variant. There have been more social restrictions imposed in other countries too. It’s a far cry from the full lock-down of the Spring of 2020, but it reminds us that the global economy has not yet normalised. At the margin, over the next quarter or so, there will be additional disruptions to spending, employment, travel, leisure consumption and the provision of goods and services. There may also be increased pressure on health systems with the political repercussions that brings, especially with electorates weary from the pandemic and its impact.
With hindsight it was clear what needed to be done to offset the economic impact of COVID. Rates were cut aggressively by central banks and spending was increased by governments. This sustained income and demand. In recent months the conversation in economic circles has been around reversing those stimulus policies and 2022 was shaping up to be the year of rate increases and some fiscal rowing back. Higher inflation is the macro force driving those policy expectations. But now what? Raise rates to tackle inflation, or stay in accommodative mode to offset any new negative impact from COVID?
You can infer most scenarios from how the bond market is currently priced. There are almost three rate hikes from the Fed priced in for 2022. For the UK it is almost four. The market differentiates between these two and the European Central Bank, pricing in less than one hike next year. Federal Reserve (Fed) Chair Powell signalled a more hawkish stance recently and since November 30 US markets have underperformed in both equity and fixed income space (EuroStoxx 1.98% vs S&P500 0.32%; German bunds 10-yr plus index 0.81% vs US Treasury 10-yr plus index 0.40%). Growth and technology heavy stocks have underperformed while value, Europe and emerging markets have outperformed.
A lot has been priced in to the front-end of US and UK curves and markets have reacted. However, further along the yield curve is it not so clear. Benchmark yields are unchanged to lower compared to when Powell pivoted. Generally, yields are well within the ranges that they have traded in during 2021. The message from the bond market is that central banks might start tightening but the global economy will slow, and inflation will ease and, therefore, long-term interest rates don’t need to go up.
This schizophrenia is not likely to disappear. It means owning bond funds is not going to deliver very negative returns any time soon. It’s difficult to think central banks will raise rates when COVID-19 cases are rising globally. At any rate, to get to the same level of US and European bond yields that were reached in the last monetary tightening cycle – 2015-2018 – would require real yields to rise by a huge amount (280bps in the US and 115bps in Europe). I have not seen a single convincing argument as to what would drive that kind of move.
Do the math
Real yields rose (in a structurally declining trend) in the US in each of the three last tightening cycles. But not on a one-for-one basis with Fed Funds. Indeed, looking back, for every 1% increase in the Fed Funds rate, real 10-year yields only increased by 0.15%. If the Fed raises the Fed Funds target by 200bps, on this basis real 10-year yields will go up by 0.3%. Assuming inflation break-evens at 2.40%, that gives a 10-year nominal yield of 1.7%!
The bond bear story needs a convincing narrative on either a more aggressive Fed, a rise in real yields that we have only seen during the 2013 taper tantrum, or a rise in break-even inflation that suggests the Fed has lost control of long-term inflation expectations. If you are convinced with any of these narratives, then stay with bonds, especially credit where you can get more carry. And for bond markets in Europe the narrative towards much higher yields are even more negative. Perhaps, in the UK, the political, policy and inflation uncertainty requires a larger risk premium than in Bunds or Treasuries.
Early 2022 is going to be messy I think. Apart from the COVID-19/inflation issue there are growing geo-political concerns around Russia and Ukraine and around China’s stance towards Taiwan. In Europe, there is the potential for things to turn very badly in the UK where the government is under attack on a number of fronts and there is the French Presidential election in the Spring. A less clear growth and inflation outlook than in 2021 and more policy uncertainty surely adds up to a more difficult return environment. Equity index returns have been between 20%-30% in 2021. These are unlikely to be repeated.
Q1 virus curve is key
If it becomes clear that Omicron is not that serious and can contribute to the final endgame where COVID is concerned, then the outlook tilts to a more expansionary way. The next few weeks might see a huge wave of new cases related to the variant and then a rapid decline in cases as 2022 unfolds. But these things do take time as we have seen from previous waves. Under that more optimistic scenario, rates will rise and the focus will be on controlling inflation over the medium-term. What will determine market performance then is how the global economy responds. There is a lot of momentum in growth, in the effects of policy stimulus and in corporate earnings performance. What is priced into rates so far should not be that damaging. Bond yields could rise (notwithstanding the real yield issue) and that could provide a positive signal for cyclicals again – I would expect European and Emerging Market equities to perform better. Lastly, look at China. The policy easing announced this week has propelled Chinese equities to being the best performing market.
Enjoy the holidays before the “fun” starts again
Keep open minded until we have more data points in the New Year. It’s going to be a make or break year for inflation – do we revert to pre-pandemic levels of 2% or lower inflation, or have we moved into a higher regime? Inflation linked markets in the US currently price in a 5-year inflation rate that is above the moving 5-year average of realised inflation. Does this represent an increased inflation risk premium? Probably. The worst case scenario is that central bankers take the view that they need to crush inflation – real yields would then rise and economic growth would respond negatively. This a possible outcome but we need to wait and see a little longer as to what the data brings.