A tangled web: Avoid the venom in bond market tail risks

Understanding apparent similarities that hide important variations across species can also be instructive for bond investors today. As well as spiders, the autumn equinox also brought the much-heralded rate cut from the Federal Reserve. In fact, the Fed was somewhat late to the party following earlier cuts from the central banks in the eurozone, UK, China, Canada, New Zealand, Switzerland and Sweden. The outlier in this story being the Bank of Japan which raised rates over the summer, albeit only to the far from venomous level of 0.25%.

At face value this is good news for bond investors – despite the recent rally in yields, bonds still look good value; for example, US 10-year bond yields hover around 3.8% at the time of writing, still higher than at any point in the last 13 years and also above annual headline inflation at 2.5% (which is expected to fall further in coming months). Bonds have also reclaimed their role as a hedge for risk assets like equities. Investors will recall a painful 2022 when equities and bonds traded down together as inflation trended higher and central banks tightened policy, handing out negative returns almost everywhere (i.e., equity and bond returns were positively correlated). But with inflation trending back to target, and with more rate cuts still expected to come a negative return correlation seems more likely.

So, inflation beating income and good portfolio risk hedging potential; what’s not to like in bonds here?

Our Fixed Income Investment Forum met recently to consider exactly this point. The conclusion was straightforward; as inflation falls back to (or even below) target in many countries, and central banks are mostly in the early stages of an expected series of rate cuts, this should be an unequivocally good environment for bonds.

But our Spidey-senses were also twitching as we looked in more detail at the global picture, and in particular market pricing.

In the US, although some concerns about the overall health of the economy are emerging – most notably in some labour market weakness – it still ranks among the best performing economies globally. Consumer and business activity have remained strong and some domestic price pressures remain, particularly in core services. This suggests to us that the feared hard landing of a recession is only a tail risk for late 2025 or early 2026. But market forward pricing implies the Fed will cut rates to below 3% by the end of 2025 (a full 2% lower than today). This is well ahead of the Fed’s, and our own, expectations. So a lot of good news is already priced in and this could be a headwind to even better bond returns from here.

This is in complete contrast to the eurozone where growth is running well below trend at just 0.6% consensus for 2024, compared with 2.6% in the US. The region’s largest economy, Germany, is flirting with recession too. Eurozone domestic demand has barely grown since 2019, business and consumer activity is relatively weak and headline inflation dipped below 2% in September. And while the ECB has cut rates twice over the summer, the communication around further easing to come has been mixed, even though the situation on the ground seems to call for more strident action. As a consequence, market forward pricing for the ECB surprisingly points to slightly fewer rate cuts, and delivered more slowly, than at the Fed. In this case we infer that market pricing hasn’t priced the overall weakness enough and the bond market has some potential to outperform the US in the months ahead. And then there is China, where bonds yields have been falling steadily since 2020 as the economy struggled to escape a late exit from COVID restrictions and a deflating property bubble. After a gradual rollout of policy support that failed to get traction, or even generate much investor confidence, the authorities recently announced an array of aggressive measurers to lift the economy out of a deflationary spiral. These included a cut in the Reserve Ratio Requirement for banks (which can potentially stimulate lending), a cut in the bank funding rate, new capital for state owned banks, a cut in mortgage rates, lower down-payment requirements, a government facility to buy unsold homes and a stabilization facility for the stock market. All this came with strong hints of more fiscal policy support to come. Long-run implications of this policy remain to be seen, but the immediate effect has been to push 10-year bond yields about 20 bps higher and introduce a new level of volatility into a market that until then had been among the best performing.

Across the world’s three largest economies the simple interpretation is that easier monetary policy is coming everywhere, and all at once. But looking closer, a realistic assessment must be different; in terms of the degree of policy support to come, the risks around it and how the risks should be priced.

It’s the same almost everywhere you look; countries like Sweden and Switzerland, where improvements in inflation are running ahead of expectations, contrast with the UK and Australia where inflation has been stickier than policymakers had hoped and rate cuts will likely be delivered more slowly than elsewhere. Policymakers and investors talk about the rate cuts to come, but by how much and how quickly will be radically different around the world.

This is good news for active global bond investors who can rotate their allocations across markets to benefit from the income and risk diversification characteristics of bonds, while steering holdings towards countries they believe have the best risk/reward characteristics. In our global strategies today this means a tilt towards the eurozone and a curve steepening bias in the US (i.e., we think that the risk/reward still looks better in short-dated bonds).

And, while we have our base case expectations around how these stories will play out into 2025, we must accept there are some events that can easily knock markets onto a different track. The US election in November is one of the most obvious, but handicapping possible outcomes, and the economic and market implications, is anyone’s guess today. So it is best not to be too dogmatic about the likely election outcome now but retain the ability to react quickly to changing events (i.e., stay focussed on liquidity).

Similarly, current events in China need close attention. The level of policy stimulus outlined above, coupled with deeper fiscal measures likely to come, will certainly have spill-over effects for the global economy. If the US economy is already doing better than many people think, and if Chinese household and business investment is knocked out of its torpor, then the global growth outlook will be better than current consensus forecasts, inflation probably higher, and much market pricing for terminal rates probably wrong (i.e., central banks will not be able to cut as deeply as expected).

As we move into the final quarter, against a backdrop that we believe is still positive for bonds, there is no room for complacency. Investors must pay close attention to differences (and pricing) across global markets even if central banks pursue similar policy rate paths. And maintaining reasonable levels of liquidity will enable quick adjustments in positions around major risk events that are still to unfold. The male house-spider starts the day with a single-minded focus on one goal, but with an unexpected catastrophic outcome. Don’t make that mistake.