Duration matters

Big picture view – history is on your side

The historical evidence from the US 10-year Treasury market is that when the central bank stops hiking and moves to easing mode this has been a good environment for sovereign bonds. This is the case whether you look at the period of persistent higher inflation in the 1970s or more recent history as shown below. The chart below separates change in yields into two historical periods: the 1969-81 period (characterised by rising and high inflation) and the 1984-2018 period (characterised by declining or low inflation). Overlaid is the most recent experience from July 2023.

So far in 2024, bond yields have backed up from the two-month collapse in yields seen in November / December last year. This is not a huge surprise in the sense that markets rarely rally in a straight line. The performance of US 10-year yields since July 2023 (black line) has continued to track the average in the 1970s (orange line) with frightening precision (given that this is an average of three cycles). If bond markets continued to follow this more rangebound path, then bond yields would still provide income but the potential capital gains from a material decline in yields would not occur until Q3 2024. Conversely, we could reconnect to the 1984-2018 average path (blue line), which could see yields decline materially over the next 18 months.

This, together with an assessment of different economic factors and lead indicators, encourages us to favour a long duration stance. Recall that bond prices rise when yields fall, and vice versa, so a longer duration stance offers the potential to capture more capital gain if yields fall.

Where are we today?

In terms of what’s new so far this year, a few things stand out:

Very strong demand for core fixed income – this is seen in European government bond auctions where investor demand broke records, in terms of the amount by which bond issues were oversubscribed, while total bond sales across European governments and corporates reached a record €280 billion in January 2024.¹ In addition, we have seen record US investment grade corporate bond supply (issuance), and investor demand more than matching it, given that credit spreads have continued to tighten through this period.²

The inflation story (ex-US) continues to firmly follow the expected disinflationary path with some big downside surprises in Australia and Switzerland. The month-on-month inflation rate in January for the US surprised to the upside. But this was a function of a historically unusual divergence of market rents and Owners’ Equivalent Rent (OER) – an estimation of the rent a property owner would pay if they had to rent their home – as well as higher asset prices (which meant that ‘portfolio management services’ added another 0.1% to inflation).³ It is hard to argue either of these are repeatable, or the beginning of a new inflation story. The bigger story remains for higher 12-month (year-on-year) core inflation rates to converge down to the weaker 6-month run rates given base effects whilst high (and lagging) rents in the inflation data continue on a path to converge down to actual market rent inflation seen in the last 12-18 months. We do not think one or two datapoints derails the core inflation trends, and we still expect US core Personal Consumption Expenditure (PCE) to be around 2.2% year-on-year (yoy) by June (note, the growing wedge between PCE which is the Fed’s preferred inflation measure and core Consumer Price Index (CPI), which we believe will likely be closer to 3% yoy by June 2024). There is no guarantee that past trends will continue, or forecasts will be realised.

Growth momentum remains weak, with the exception of the US which has been the growth outlier since 2023. Most cyclical sectors continue to suggest a long bathtub shape recovery (i.e. extended trough). Growth indicators such as the ISM new orders and the Purchasing Manager Indices (PMIs) have picked up from low levels, yet the long lead indicators that we follow suggest that there is a risk of a head fake (false dawn). Historical instances of ISM new orders recovering back through 50 (a figure above 50 indicates expansion) when real money contraction was negative include 1957, 1970, 1980 and 1990. In those cases, the new orders index subsequently fell back below 45, with those relapses associated with recessions.⁴ Alongside that, we have not seen strong guidance from companies / industries during the recent earnings season to suggest a meaningful turn is here.

Evidence for our stance across different regions

While Figure 1 focused on the US due to the long data history, if we look globally there are opportunities for the portfolio where underlying growth momentum is weaker – this is critical as we believe that the rate of change in growth momentum drives bond yields.

• UK – the Bank of England (BoE) is seen by some as a potential laggard in rate cuts, with higher core inflation / wage growth than elsewhere. In the February meeting, the Monetary Policy Committee was split, with the majority of members (6) voting to hold rates, while two called for a rate hike and one for a rate cut. The labour market is loosening, which is not so visible in the official numbers due to a low response rate, but job vacancies have fallen for 20 consecutive months.⁵ In addition, UK firms did not see the profit margin expansion of US or Europe, so from that perspective they could be the first to cut jobs. It is also worth noting the pace of fiscal consolidation (downward change in government borrowing) in the UK this year is expected to be greater than that of the US or the Eurozone.⁶ In that regard, monetary policy may need to do more to stabilise the negative drag on the economy and we may see the BoE forced into more aggressive rate cuts later. Moreover, the UK is no longer an outlier on inflation. In fact, we believe UK headline CPI inflation could be below the 2% target by April / May, and could even hit 1.5% by the summer thanks to not only the reduction in the energy price cap, but also lower goods and food inflation. To us, the downside risks (to yields) are being underestimated. There is no guarantee that past trends will continue, or forecasts will be realised.
• Europe – we expect the European region to be at the forefront of rate cuts due to the extremely weak growth outlook, and rapid disinflation. This is unusual in that it is typical for central banks to follow the Fed, but it could well be that the Swiss National Bank and European Central Bank (ECB) move earlier. The debate is around when the first rate cut could occur with the doves favouring April and the more hawkish members of the ECB Governing Council favouring June. With all the concerns about fiscal largesse and excess bond supply, it is important to remember that in Germany, despite near zero economic growth, the commitment to fiscal discipline and aversion to increasing debt is high (the debt brake, which limits German government borrowing, is enshrined in law since 2009).
• Australia – the Reserve Bank of Australia (RBA) has been saying that additional rate hikes cannot be ruled out, but to us economic momentum is fading as evidenced by a string of inflation, employment and other misses in the economic data this year. The unemployment rate has risen by 0.6% from the lows.⁷ Employment is at risk of weakening more than expected as prior strong population growth feeds supply, while demand moderates. A second phase of the slowdown is via investment, from a slowing of public sector investment and soft private investment. The transmission of rate hikes to the economy should happen faster than elsewhere due to the housing market where mortgages are predominantly floating rate (i.e. not fixed for long terms so move with the change in interest rates).⁸ This is showing through in the change in real disposable income over the past 18 months, which is among the weakest in the OECD.⁹ The yield curve in Australia is firmly upward sloping beyond the short term, while 10-year yields are well above 2-year yields; this creates potential for enhanced income when the yield is hedged back into other currencies, such as GBP.¹⁰

Duration of the strategy

We have maintained duration at the top end of the range (circa 9 years) despite the more frustrating path that yields have followed (see Figure 1). In our view, this is the wrong time to be cutting duration because evidence is building that we are entering rate-cutting territory, which historically supports declining yields. Under the surface, we have rotated exposure around geographies in the developed world (and maturities) as reflected in Figure 3.

Summary

We expect our long duration position has the potential to perform irrespective of whether we see a hard or soft landing for the economy, on the assumption that the downward trend in inflation allows central banks to move to easing policy.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

There is no guarantee that past trends will continue, or forecasts will be realised.