BOC strategist: 2023 should be a good year for bonds

2022: A Very Bad Year for Bonds

2022 will go down in the record books as one of the worst years in history for bond market performance. Ten years of zero interest rates, fiscal and monetary stimulus, benign inflation and low volatility in financial markets all contributed to positive bond returns and led to complacency among most investors that this environment would continue indefinitely. However, upside inflation surprises caused central banks to raise rates aggressively, sending yields higher and bonds lower, US Fed Funds currently at 4.33% are at their highest since 2007 and, in the Eurozone, the ECB main refinancing rate stands at 2.50%, a 13-year high.

What Goes Up Must Come Down and Vice Versa. Buy Bonds

A look at the annual returns of the US Government 10- year Bond (Chart 2) since 1974 suggests that large negative returns are usually followed by a positive return going forward. Although the idea that because something has gone down it should then go up is not a trading strategy, the fact that bonds are a core component of most portfolios and, as they decline their yield rises, making them more attractive, does lead to increased asset allocation flows.

Recession Risk. Buy Bonds

A favourable time to buy bonds is before a recession, when investors anticipate a slowdown in economic activity and rotate out of riskier assets and into the relative safety of fixed income securities. Typically, they are expecting the Federal Reserve to lower interest rates to stimulate the economy. Chart 3 illustrates an inversion (below zero) of the US 2-10 Yield Curve. This happens when long-term yields (10 Yr) fall below short-term yields (2 Yr). The shaded area represents a recession in the US and shows that an inversion of this curve precedes a recession. However, the problem with this signal is that it doesn’t tell you when a recession will start, how long it will last or how severe the downturn will be. In addition, the current market consensus is for a recession this year and this is reflected in today’s prices.

Bonds Relative to Equities. Buy Bonds

One measure of comparing bond valuation relative to equities is to take the yield of an equity index minus the yield of a bond and plot this value over time to gauge where we stand today. Chart 4 shows the yield difference between the S&P 500 and the yield on a US Government 10-year bond. The average yield over the last 10 years has been around 3%. As this indicator is usually mean reverting, it favours buying equities when it is above 3% and buying bonds when it is below 3% on a relative basis. It is currently at 1.58% (5.07% - 3.50%).

However… Leading Indicators. Be Cautious

Leading indicators are measurable sets of data that can help to forecast future economic activity. Often it is useful to look at the fluctuations and trends in commodities and shipping as strong or weak activity in both will give clues to future economic expansion or contraction. Unfortunately Chart 5 paints a mixed picture. While freight rates have declined throughout 2022, commodities markets, have bounced off their lows driven by China reopening their economy.

Don’t Fight the Fed… or the ECB for That Matter. Stay Neutral

The saying “Don’t fight the Fed” means that investors would be wise to align their own strategies with the actions and guidance of the Federal Reserve. Both the Federal Reserve (Fed) and European Central Bank (ECB) have been clear in their commitment to raise interest rates to a restrictive level, tightening financial conditions to curb inflation. The Federal Reserve at first ignored the higher spike in inflation, calling the move “transitory” and then aggressively raised rates to catch up with a US Consumer Price Index at levels not seen since the early ‘80s. Although inflation is coming down (US CPI YoY 6.5%), it is still above the 2% target, while the US unemployment rate is at its lowest levels in fifty years, signalling that the current hikes have yet to feed into the labour markets. Present market expectations (Chart 6) expect the Fed to start easing around June/July but this looks optimistic to us, as the risk of cutting early and being wrong outweighs the risk of keeping rates higher for longer and causing a recession.

“Prediction is very difficult, especially if It’s about the future!”

(Niels Bohr, Nobel Laureate in Physics)

Whenever making a forecast it is always good to remember what one of the greatest minds of the 20th Century (Niels Bohr) had to say on the matter of predictions. The best we can do is assign probabilities to certain outcomes and adjust them as more information becomes available. For long-term bond investors following a passive strategy, we expect 2023 to be a good year driven by flows locking in yields amid fears of an imminent global slowdown. For those active investors who look to tactically time the markets, we would suggest that there may be a better opportunity to buy bonds as the market accepts that central banks are unlikely to pivot as fast as they currently anticipate and will keep yields higher for longer. Within the bond space we prefer Government and Investment grade bonds relative to High Yield bonds, as investors focus on safety as economic headwinds intensify.

Investment Strategy & Advisory Manager, Bank of Cyprus Asset Management

(This article first appeared in the February 2023 issue of GOLD magazine. Click here to view it.)

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