An optimist’s guide to the bond market

{"text":[[{"start":null,"text":""}],[{"start":5.7,"text":"Good morning. What does a country gotta do to get lower bond yields around here? The US personal consumption expenditures inflation index — the Fed’s preferred measure — came in softer than expected in August, at a 3 per cent annualised rate, excluding food and energy. More important, perhaps, the prior two months’ readings were revised down, leaving the three-month rolling average (the pink line below) at 2 per cent, the central bank’s target: "}],[{"start":null,"text":""}],[{"start":31.25,"text":"Cue celebrations in the bond market? Umm, no. The 10-year Treasury yield rose four basis points, to 5.29 per cent, yesterday. What gives? Well, part of the decline in PCE (just how much is unclear) was down to a change in how the index handles financial services prices. And, as the chart above shows, the longer-term trend still looks more sideways than down. Most important, though, the growth story is rocking and rolling: second-quarter real GDP was revised up from 1.5 per cent to 2.2 per cent yesterday. A good reminder that the bond market story is not just about inflation. Email us: [email protected]"}],[{"start":73.05,"text":"This is fine?"}],[{"start":75.64999999999999,"text":"Dear oh dear, what a month September was in the rates markets. US benchmark 10-year yields gained half a percentage point, with some rather gut-wrenching days in the mix that have, I gather, hammered some hedge funds. You have to go back to 2022, a proper bond bloodbath, to see that kind of action. And the pain has been pretty widespread, with US yields making life difficult for everyone else. Check out Norway, for example: its debt-to-GDP ratio is a little over 50 per cent — rookie numbers by developed-world standards — and its yields are still getting dragged higher."}],[{"start":109.1,"text":"We asked the other day whether hopping into bonds now would represent a savvy bit of dip-buying or the investment equivalent to jumping into a meat grinder. Most respondents opted for meat grinder. However, it is still possible to turn that frown upside down. "}],[{"start":125.6,"text":"The first reason to be cheerful is that, thankfully, this is not 2022, when bonds and stocks both tumbled together. Sure, it looks like the ascent in bond yields is keeping a bit of a lid on the stock market, but the latter is not in distress."}],[{"start":138.4,"text":"As Jurrien Timmer, director of global macro at Fidelity Investments, pointed out in a LinkedIn post the other day, the secret ingredient is earnings."}],[{"start":148.95000000000002,"text":"if the 10-year yield rises to 6%, that suggests an equity P/E ratio of 16x. [The S&P 500] is currently 19-20x. A 4-point drop in the P/E ratio is a 20% valuation haircut, but if it’s offset by 30% earnings growth, we could be spared the kind of drawdown we experienced in 2022. Maybe a 2022 echo or aftershock."}],[{"start":null,"text":""}],[{"start":172.85000000000002,"text":"Second, this is what bonds are supposed to do in a growth-y environment. We’ve all had our brains scrambled by the quantitative easing years. Yes, this shifts the burden from central banks to governments, and it will all impose some tough political choices on countries like the UK and France that rely heavily on borrowed money. But maybe it is time for us all to take that medicine."}],[{"start":194.40000000000003,"text":"Third, a related point, this is not a solvency crisis or anything like that. It is the effluent coming off a massive repricing on the path ahead for the Federal Reserve. We all had our doubts that the Fed would be able to stick to the script and raise rates to tackle inflation. Chair Kevin Warsh put those doubts to bed in Jackson Hole and forced the market to flip expectations. Bear in mind at one point last year, the market was pricing in five interest rate cuts from the Fed in 2026. Now it is pricing two rises — one done, one to go."}],[{"start":225.95000000000005,"text":"Fourth, and OK maybe this is not exactly a reason for normal people to pop the champagne, but this is a nice set-up for hedge funds, or at least for the hedge fund managers who have not already been carted out by the rates market in September."}],[{"start":240.10000000000005,"text":"As UBS Wealth Management said in a note yesterday:"}],[{"start":244.20000000000005,"text":"Major central banks [have] made clear that interest rates will need to remain high in the near term amid sticky inflation and resilient economic growth."}],[{"start":253.35000000000005,"text":"Historically, such a global policy environment has been favourable for hedge funds. They generated positive cumulative returns during every Federal Reserve tightening cycle since 1994 and generally outperformed global bonds. In the most recent cycle, global bonds fell by around 12%, while hedge funds ended the period with positive returns."}],[{"start":275.25000000000006,"text":"Fifth, we all know that markets are prone to overreaction. It’s possible this is that overshoot at work, especially now that the rates markets are dominated by more price-sensitive buyers. Reasonable people can disagree here, but the market is pricing in a further four rate rises from the Fed in this cycle. Really?"}],[{"start":293.25000000000006,"text":"Olivier de Larouzière, chief investment officer of fixed income at BNP Paribas Asset Management, is saying “non.” He reckons there’s maybe one more rise to come. The shorter end of the market has been “brutal”, due to that rates repricing, he says, but “apart from that, nothing much has happened”, and as such, he’s a buyer of G-4 rates out to a maturity of five years. “The macro is stronger than expected,” he said. “Bond markets are supposed to suffer.”"}],[{"start":322.8500000000001,"text":"Pain and suffering are how fixed-income people enjoy themselves, and hey, maybe there’s more of that to come. But if this is an excessive market response to the Fed, he could have a point."}],[{"start":334.3500000000001,"text":"One good read"}],[{"start":336.4500000000001,"text":"Syria’s free-market experiment"}],[{"start":null,"text":""}],[{"start":null,"text":""}],[{"start":null,"text":""}],[{"start":344.6500000000001,"text":""}]],"url":"https://audio.ftcn.net.cn/album/a_1790847103_3986.mp3"}