Market news and some thoughts on bonds.
Market News
Treasuries are having their best day since March, with 10-year yields down as much as 18 basis points after dovish comments from Fed officials and as conflict in the Middle East fuelled a flight to safety. Traders are betting the Fed’s most aggressive tightening cycle since the 1980s may be over. Top central bank officials have hinted that tighter conditions after the yield surge may stand in for further rate hikes. Fed Vice Chair Philip Jefferson said he would “remain cognizant of the tightening in financial conditions through higher bond yields” in assessing future policy. The yield on the policy-sensitive two-year Treasury dropped by the most since the end of August, while the benchmark 10-year had its best day since March.
US equity markets also rose last night – S&P 500 (+0.6%); Nasdaq (+0.4%) – while this morning in Asia shares followed Wall Street higher: Nikkei 225 (+2.4%); Hang Seng (+0.8%). The FTSE 100 is currently trading 1.0% higher at 7,563. Gold is firm at $1,857 an ounce.
Catherine Mann raised concerns that the prolonged period of above-target inflation may fuel expectations of future price increases. The Bank of England policymaker said an “aggressive” approach to tackling prices was needed. UK retailers reported sluggish sales in September as squeezed consumers cut back on big-ticket spending and unseasonably warm weather delayed purchases of winter clothing. Retail sales growth slowed to 2.7% year on year from 4.1% in August, the British Retail Consortium and KPMG said. It was the second-weakest month of the year so far and the rate of expansion was well below inflation, meaning the volume of goods sold fell. Sterling currently trades at $1.2221 and €1.1570.
The oil price steadied after its biggest jump in six months. Brent Crude is $87.10 a barrel. The S&P 500 Energy Industry Group GICS Index rose by 3.5%.
Source: Bloomberg
Bond Market View
There has been a dramatic change in the investment environment, so that in some ways bonds are much more attractive than equities, albeit with a caveat. That change is the generational move higher in bond yields, but specifically real yields, that has occurred in only a two-year period and reversed twenty years of the previous trend. The chart below shows the real yield of UK index-linked bonds (linkers) has gone from -2.4% to +1.5%.
UK 20 Year Real Yield
Source: Bloomberg
To illustrate what this means, at the beginning of 2022 you would have had to invest £1,630 to have £1,000 of purchasing power in 20 years. Today that number has fallen to £730. This is an extraordinary change. In the US, the same figures are $1,050 two years ago and $590 today. In this regard, the environment is much less hostile than it was. This is a manifestation of the risk of holding long duration at negative real yields. The hit to long duration treasuries has been greater than the hit to equities in 2008/9.
Long Bond Drawdown
Source: Bloomberg
S&P 500 (2008-09)
Source: Bloomberg
The reason to focus on index-linkers is that although they have suffered at least as badly as nominal bonds to date, and may continue to do so, they have a significant advantage. One of the big reasons the long end of the yield curve is so weak is the supply/demand imbalance for the debt – it is NOT higher inflation expectations. We believe if the economy hits a brick wall and yields start to fall, both types of bond will benefit. The linker might do less well if the weakness causes breakevens to fall. However, if yields continue to rise as they have been, and central banks are forced to control them, long-term inflation expectations could rocket, meaning the linkers will do much better.
There are all sorts of risks in markets but one that is under-appreciated is reinvestment risk. We see no reason why the economy is in a better place to handle materially higher real yields than it did five years ago. We believe there is a reasonable probability these rates will fall in an ugly recession leading to a material gain in these bonds. Those feeling safe and secure at the short end, while looking at the carnage at the long end, will feel differently if rates collapse again, and they have to reinvest at zero, and longer-dated real yields are negative again. Think of it like a fixed mortgage but in reverse – when should you fix and when should you stay floating?
Look at it from the US perspective. Let’s say 20-year real yields rose to 4%, i.e., you are guaranteed to make 4% above inflation with no risk. Why would you bother with anything else? These instruments are still risky because of the duration but in the belly of the curve in the UK and US (say 5-10 years) – albeit the latter comes with FX risk for a sterling investor – you can get positive reals for modest price volatility.
The caveat we referred to at the start is in relation to equities. The caveat being that US equities are materially more expensive than the UK, Europe, and the rest of the world. UK stocks in the FTSE 100 for example are on a 9% earnings yield. That gives them scope to beat even these real yields handily over time. In the US, this is much less clear cut. The big seven stocks are about the most expensive financial assets on the planet.
In order to close the gap, you need to see an asset class rotation from big money. Eventually we think this will come, although it is hamstrung by the fixed allocation strategies that dominate the investment framework, i.e., they will rebalance to keep their target weighting which will have an impact, but they won’t change their target weighting.
In summary, bonds much better than they were, index-linked are better than nominal, duration adjusted to your risk appetite. Being balanced to these risks is better than an all-in bet one way.