Going on an Easter bond hunt

In the blink of an eye, we are already almost three months into 2024 and with Easter arriving early, we will soon be a quarter of the way through the year. Questions will once again be asked about whether this is truly going to be the year of the bond. However, for the second year in a row, the anticipation of core fixed income returns has proven greater than the reality over the opening weeks of the year. Following the Federal Reserve’s (Fed) dovish pivot in December, bond yields moved significantly lower to close out 2023, driven by the expectation of looser policy and light liquidity into year-end. As a result, fixed income delivered very strong performance.

Since then, economic data for January poured cold water on those calling for aggressive central bank easing in 2024. In the US, strong jobs data and upside inflation surprises caused a repricing of Fed interest rate cut expectations this year from almost seven 25 basis point (bps) cuts in mid-January to around 80bps today. Current expectations are more in line with what the Fed’s dot plots have shown it expects to deliver. This has led to yields reversing part of the Q4 move, with the Bloomberg Global Aggregate Index yield moving up over 25bps and leaving the index slightly negative year to date.

So is now the time to go on an Easter Bond hunt into the forest of fixed income, or are we underpricing the risk that central banks are going to struggle to justify easing in line with market (and their own) expectations?

Despite the volatility, we don’t believe the answer from the start of the year has changed. It is still a favourable environment to be investing in fixed income but it is worth clarifying why and what could impact the market during the rest of the year.

First, the ‘pivot’ we witnessed at the end of last year by Jerome Powell was not a mistake or misinterpreted. It does appear that central bankers would like to begin easing policy this year. They believe that they have taken rates into significantly restrictive territory, are encouraged by the decline in inflation and know that monetary policy works with lags. In short, their motivation to cut rates is to maintain the soft landing and avoid pushing economies into recession. Powell himself stated this during an interview on the 60 minutes TV show on the 1 February:

“All but a couple of our participants do believe it will be appropriate for us to begin to dial back the restrictive stance by cutting rates this year. And so, it is certainly the base case that we will do that. We’re just trying to pick the right time, given the overall context.”

It is not just the Fed that has hinted a bias towards policy easing. Both the European Central Bank (ECB) and Bank of England (BoE) are pointing towards cuts later this year as well. At a press conference following the March ECB meeting, President Christine Lagarde stated:

"We did not discuss cuts for this meeting, but we are just beginning to discuss the dialling back of our restrictive stance"?

While BoE Governor Andrew Bailey – who arguably has had a more challenging environment with headline inflation still double the Bank’s 2% target – recently stated inflation does not need to fall to target before policymakers support an interest-rate cut.

With rhetoric from central bankers across the developed markets remarkably consistent, it would seem that the data, particularly inflation data, would need to strongly point towards a re-acceleration for multiple months to force them to reverse their stance.

Which, helpfully, leads us onto the data. While the US January data did surprise to the upside, this was not repeated to the same extent in February. There are still signs of a healthy jobs market with the three-month average of monthly non-farm payroll growth ticking up to 265k for February. However, the Fed can take comfort from negative backwards revisions to previous months (the upside January report was revised down to 229k growth from an initial reading of 353k) alongside slowing wage growth from both the February Average Hourly Earnings reading and the Q4 Employment Cost Index. Additionally, some of the leading indicators ,which include the openings, quits and the jobs hard to fill for small businesses, are all pointing towards a cooling in activity.

On inflation, the rapid decline witnessed in 2023 has taken pause but the longer term disinflation trend remains in place and even though the Federal Reserve lifted their year end forecast for core personal consumption expenditure (their favoured measure of inflation) at their most recent meeting from 2.4% ?to 2.6%, they continue to believe it is coming under control and indicated they still expected to be cutting rates three times in 2024 even in light of the information they have received this year.

Outside of fundamentals, the technical demand for bonds remains impressive, and it does not appear to be slowing. Fund flow data shows a healthy allocation coming into the market, particularly in core aggregate strategies, with the 12-week rolling flows into US high grade bonds increasing to levels not witnessed since the summer of 2021.

Another indication of the strong demand for bonds is highlighted by the new issuance market which has been on fire this year, breaking volume records while still being taken down by end buyers. US investment grade credit issuance is running at a rate 30% greater than this time last year, while the spread on the index has actually shrugged off the aggressive issuance and moved tighter by over 10bps year to date.

The final argument for bonds is valuation and diversification. If anything, these factors have improved since the start of the year with the repricing in markets.

Valuations look compelling both in real terms and relative to where nominal yields have been over the last couple of decades, particularly in the core, high quality space. With inflation falling, real yields are back handsomely in positive territory. A basket of global government real yields which had bottomed at -2% in late 2021 is now yielding 1.40%, which is back to levels we saw prior to the Global Financial Crisis. Looking across a range of sectors going back over the last 20 years, which incorporates the last period of ‘normal’ monetary policy, it shows that core sectors have yields above median levels and up towards the top of those ranges.

Finally, the strategic rationale to own bonds for diversification remains intact. With monetary policy still restrictive, if something does break in the economy central banks have a lot of ammunition to lower interest rates quickly and significantly, which would generate large positive returns for high quality fixed income assets.

Investors should continue their hunt to find Easter Bond treats. The repricing in markets, alongside the willingness of central bankers to hand out chocolate eggs should be supportive for fixed income and the extension of the business cycle.

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