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Less than two months ago, the angst running through markets was real. Who will buy US government bonds? Are we standing on the precipice of a buyers’ strike that destabilises global markets?
It now looks safe to say the answers to those questions are: lots of people actually, and no. Worrying about how investors will absorb the vast and swiftly swelling flood of newly issued Treasuries made sense then and it still makes sense to factor it in now. The growing borrowing requirement of the US government is likely to keep prices a little lower, and therefore yields a little higher, than they might otherwise be.
But while this will be a hot topic for years to come, “bonds are not potatoes” as HSBC’s bond strategy supremo Steven Major is always keen to stress. The equation is not quite as simple as “more bonds mean lower prices”. Few are compelled to consume spuds for regulatory reasons, for example, and tubers are a poor store of long-term value.
And far from a buyers’ strike, bonds have been enjoying a startling run. November was the best month for the asset class in the US in almost 40 years — a rally that has sent benchmark 10-year US government bond yields down from 5 per cent in mid-October to just 4.3 per cent or so now. In turn, this has fuelled the biggest monthly jump in global stocks since the same month in 2020.
The market has leapt directly from a certainty that interest rates will be higher for longer to a firm suspicion that, in fact, central banks will take sliding inflation levels as a cue to start cutting rates possibly even as soon as next spring. This smells somewhat excessive, but it is foolish for investment to stand in the way for now.
“We’re not going to see 5 per cent on the US 10-year again,” said Karen Ward, chief market strategist for Europe at JPMorgan Asset Management. “If you missed 5, don’t miss 4.5. Bonds are very high on the Christmas wishlist in my house.” Festive times in the Ward household.
Mark Cabana, head of US rates strategy at Bank of America, said in a briefing this week that potentially record-breaking levels of US government bond issuance next year were “daunting”, but he was “cautiously optimistic”. He has broken down key bond buyers in to several categories and concluded that each of them is likely to fall back in love with the asset class in 2024.
First up is asset managers, which normally buy bonds to balance out risks in other supposedly racier markets. This went badly wrong in the horror show of 2022, when stocks and bonds fell in tandem. And the strategy backfired initially this year when asset managers went all-in on the idea that 4 per cent yields were the top. Now, finally, that “frustrating” period is coming to an end and they are likely to prove more willing to step in, said Cabana.
Overseas institutional investors, particularly in the UK and Europe, are also likely to be more enthusiastic, after currency hedging costs have flipped markedly in their favour. Banks are also enthusiastic buyers as they seek to build up buffers against shocks.
Meanwhile in Europe, another widely overlooked potential support for bonds comes from a German constitutional court ruling that freezes some additional fiscal spending. So far, the decision has failed to produce anything close to the levels of market alarm associated with spending brakes in the US. The bet is that politicians in Berlin will somehow figure this out in a sensible and pragmatic fashion.
Still, the ruling comes as the Germany economy is stumbling. And Robert Dishner, a senior portfolio manager at Neuberger Berman, says it does suggest that “Europe is going to slow in a more material way”. Partly as a result, the European Central Bank “may be the first major central bank to cut rates”. No wonder benchmark German government bond yields are back down to summer lows.
The short-term issue is that this love-in with bonds looks rather frothy. Cabana noted that some of his yield targets for the end of 2024, let alone this year, are already within reach. So while Bank of America is looking for around 0.75 percentage points of Fed cuts next year, starting in June, the market is pricing in closer to 1.2 percentage points, from May. His target for five-year yields at the end of 2024 is 4.15 per cent. We are already at 4.2 per cent.
But longer term, both the optimists who believe the Fed can engineer a soft economic landing and those of a more pessimistic persuasion are happy to ride this wave.
“Soft landings are a bit like unicorns. They don’t exist,” said Mike Riddell, UK fixed income manager at Allianz Global Investors, who is clearly in the latter camp. He sees an “extremely high risk of a recession”.
“We adore government bonds,” he said. “We’re as full as we can be on government bonds and we’re outright short on credit where mandates allow.”
It is tricky to guess how long the Fed will let this run. The central bank was quick to signal to investors when it thought yields had climbed too high earlier this year and it could easily send a “knock it off” message if easier financial conditions in markets helped to bump inflation back up again. But for now, investors seem happy to test that limit. Buyers are not so elusive after all.
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