Insights

Over the past five years, bond markets have experienced a remarkable transformation that has reshaped the investment landscape. However, from the pandemic to the rising macro-economic pressures of today, fixed income continues to play an important role in portfolio construction. To maximise the benefits of this asset class, it is crucial to understand what has driven this market evolution and where it is likely to head next.

Chasing stability amongst global uncertainty

In 2018, interest rates and bond yields were at low levels, having been in decline since the 1990’s. Economic growth in the developed world was showing signs of strength and central banks such as the US Federal Reserve were beginning to tighten monetary policy.

However, an unprecedented storm was brewing. COVID-19 swept across the world in early 2020 and triggered a seismic shift in the risk landscape, driving investors towards the safety of government bonds and driving government bond yields to record-lows.

Central banks cut interest rates aggressively in an attempt to protect their economies from the pandemic and launched massive bond-buying programs to inject liquidity into the financial markets. 

The benchmark US 10-year Treasury bond’s yield fell to a historic low of 0.5%, while the equivalent government bond yields in Australia and the United Kingdom fell to 0.6% and 0.1% respectively. Almost unbelievably, negative yields appeared in the eurozone and were solidified in Japan.

At this point, the threat of inflation was not yet on the radar. Extremely low interest rates along with government fiscal stimulus and a vaccine fostered hope for an economic recovery. 

Supply chain pressures related to the pandemic bought with them expectations of inflation which started to push longer-dated bond yields higher. These inflationary concerns triggered fears of a tapering of central bank support and led to periodic volatility in bond markets, causing fluctuations in yields. Major central banks, such as the Federal Reserve, communicated their intention to maintain accommodative monetary policies despite the ‘temporary’ spike in inflation. Such reassurances aimed to stabilise the wider financial market and mitigate bond market volatility. 

Inflationary pressures continued to grow with Russia’s invasion of Ukraine driving energy prices skywards and labour markets tightened, pushing wages higher. This led to a sustained and aggressive tightening of monetary policy by central banks through 2022 and 2023.  Short term interest rates in the US and UK, rose above 5%, while the RBA in Australia lifted its benchmark rate to 4.35%.

However, as food and energy price inflation began to moderate, investors started to forecast a reduction in central bank rates and bond yields fell significantly over the final quarter of 2023. These moves enabled bond market indices to reverse prior losses and finish the year in positive territory, following negative returns over the prior two calendar years.

A calm surface, underlying volatility and inflation

Today, the bond yield story continues to evolve. On the surface, bond markets appear to have calmed considerably, certainly relative to the extremes of 2022 and 2023. However, beneath the surface, bonds remain highly volatile by historical standards. This is due to ongoing macro uncertainty, including geopolitical, and increasingly divergent expectations for monetary policy as the outlook for inflationary pressures become more idiosyncratic.
  
The latest data in the US showed only a modest reduction in headline and core inflation, with prices in the service sector remaining elevated.  Minutes from the May meeting of the Federal Open Market Committee highlighted concerns regarding the pace at which inflation was falling, although Chairman Powell pushed back on the potential for further interest rate hikes.

In Europe, headline and core inflation accelerated in May, but a fairly consistent decline over the preceding months encouraged the market to factor in a high probability of a 25 basis-point cut to the ECB’s main refinance rate in early June – a reduction that has since been delivered.  While support for this cut was not unanimous, the ECB believes the new rate of 3.75% remains restrictive with regard to inflationary forces and growth.

The Bank of Canada also trimmed its benchmark interest rate in June, with a 25 basis-point cut to 4.75% reflecting increased confidence amongst committee members that the 2% inflation target would be achieved in the coming months.

Headline inflation in the United Kingdom has fallen meaningfully year-to-date, but service sector inflation remains close to 6%, forcing many investors to scale back expectations for a near term cut by the Bank of England.
  
While, labour market strength and sticky inflation led some commentators to forecast further rate hikes in Australia and while that is not out of the question, RBA Governor Michele Bullock suggested that monetary policy was already restrictive enough to bring inflation back to the Bank's target band of 2-3% by late 2025.

Where to next?

From volatility suppressors to volatility amplifiers 

We are now in a regime where central banks have flipped from being volatility suppressors to volatility amplifiers. Since the financial crisis of 2008, the dual policy objectives of most central banks were aligned. Inflation was generally running below target levels, which justified a monetary policy designed to buoy inflation and support economic growth (i.e., a policy of low interest rates). At any time when economic growth appeared to be at risk, it was easy for central banks to justify more stimulus to quickly get things back on track, which meant they acted as a safety net and a volatility suppressor.

With the regime shift to higher inflation, the dual policy objectives of central banks were in opposition to each other as monetary policy tightening to control inflation, slowed economic growth and risked tipping economies into recession. As a result, central banks became volatility amplifiers.

For portfolio construction, the result of central banks becoming volatility amplifiers, combined with uncertainty around inflation, means a regime of structurally higher bond market volatility. The more variable correlation between assets classes, namely bonds and equities, has significant implications for multi-asset portfolio construction.
 
While it used to be sufficient to rely on government bond duration to diversify equity market beta, this is no longer enough. With duration now more volatile, and having a more variable correlation to equities, additional portfolio diversification levers are important. Employing strategies which are uncorrelated with lower volatility, when compared to conventional bond investments using duration or credit, can provide positive performance benefits.

Amid these stormy market conditions, defensive asset allocations still have an important role to play for investors.  As global macro-economics continue to shift and central bank priorities evolve, it will be important to carefully consider the role of fixed income in portfolio construction. To mitigate volatility and risk, a diversified, uncorrelated, high quality bond strategy that prioritises liquidity and capital preservation will be important.

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