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Market leaves Fed behind
Jenna Barnard, Co-Head of Global Bonds, believes recent market developments and weakening economic data support the view that the Fed is behind the curve.
5 Aug 2024
3 minute watch
3 minute watch
Key takeaways:
- The market environment is shifting with expectations that the US Federal Reserve (Fed) has been slow to act and may have to cut rates by 50 basis points at its September meeting.
- We have been saying for several months that lead economic indicators were weakening, particularly the more critical employment data, and that central banks needed to be cutting interest rates.
- The US 10-year Treasury yield is closely following the average path of the 1970s, suggestive of deeper declines in bond yields (and rises in bond prices) ahead if the historical path is maintained.
Definitions
10-Year Treasury Yield is the interest rate on US Treasury bonds that will mature 10 years from the date of purchase.
Behind the curve: An expression used to describe reacting to something after it has already happened.
Beta: A measure of a security’s volatility in relation to the wider market. If a security has a high beta then it is more volatile than the market. If it is low beta it is less volatile than the market.
Core fixed income: a term typically used to refer to investment grade government and corporate bonds.
Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Cyclical: Companies or industries that are highly sensitive to changes in the economy, such that revenues generally are higher in periods of economic prosperity and expansion and are lower in periods of economic downturn and contraction.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Inflation: The rate at which prices of goods and services are rising in the economy. Core inflation typically excludes volatile items such as food and energy prices.
Investment-grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments, reflected in the higher rating given to them by credit ratings agencies.
Lead indicator: A piece or set of economic data that can help provide an early signal of where we are in an economic cycle.
Maturity: The maturity date of a bond is the date when the principal investment (and any final coupon) is paid to investors. Shorter-dated bonds generally mature within 5 years, medium-term bonds within 5 to 10 years, and longer-dated bonds after 10+ years.
Owners’ Equivalent Rent: The implicit rent that owner-occupiers would have to pay if they were renting their homes.
Recession: A significant decline in economic activity (negative economic growth) lasting longer than a few months.
Yield: The level of income on a security over a set period, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, at its most simple, this is calculated as the coupon payment divided by the current bond price.
Yield curve: A yield curve plots the yields (interest rate) of bonds with equal credit quality but differing maturity dates. Typically bonds with longer maturities have higher yields. A curve steepening is where the gap in yield between short and long-dated bonds grows.
US Treasury securities are direct debt obligations issued by the US Government. The investor is a creditor of the government. Treasury Bills and US Government Bonds are guaranteed by the full faith and credit of the US government, are generally considered to be free of credit risk and typically carry lower yields than other securities.
Behind the curve: An expression used to describe reacting to something after it has already happened.
Beta: A measure of a security’s volatility in relation to the wider market. If a security has a high beta then it is more volatile than the market. If it is low beta it is less volatile than the market.
Core fixed income: a term typically used to refer to investment grade government and corporate bonds.
Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Cyclical: Companies or industries that are highly sensitive to changes in the economy, such that revenues generally are higher in periods of economic prosperity and expansion and are lower in periods of economic downturn and contraction.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Inflation: The rate at which prices of goods and services are rising in the economy. Core inflation typically excludes volatile items such as food and energy prices.
Investment-grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments, reflected in the higher rating given to them by credit ratings agencies.
Lead indicator: A piece or set of economic data that can help provide an early signal of where we are in an economic cycle.
Maturity: The maturity date of a bond is the date when the principal investment (and any final coupon) is paid to investors. Shorter-dated bonds generally mature within 5 years, medium-term bonds within 5 to 10 years, and longer-dated bonds after 10+ years.
Owners’ Equivalent Rent: The implicit rent that owner-occupiers would have to pay if they were renting their homes.
Recession: A significant decline in economic activity (negative economic growth) lasting longer than a few months.
Yield: The level of income on a security over a set period, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, at its most simple, this is calculated as the coupon payment divided by the current bond price.
Yield curve: A yield curve plots the yields (interest rate) of bonds with equal credit quality but differing maturity dates. Typically bonds with longer maturities have higher yields. A curve steepening is where the gap in yield between short and long-dated bonds grows.
US Treasury securities are direct debt obligations issued by the US Government. The investor is a creditor of the government. Treasury Bills and US Government Bonds are guaranteed by the full faith and credit of the US government, are generally considered to be free of credit risk and typically carry lower yields than other securities.
IMPORTANT INFORMATION
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.
View transcript
Jenna Barnard: It’s the beginning of August and we’ve seen some very dramatic moves in markets over the last week or so. Obviously, it’s been a very aggressive risk-off in risk assets and bond yields have collapsed driven by the US Treasury market.
In terms of what the team and myself are thinking, the direction of travel of these moves is not a huge surprise to us. Obviously, the speed and ferocity is remarkable.
But we actually did a webcast for clients at the end of June in which we talked about the end of “higher for longer” and the beginning of rate cuts across the developed world. How growth lead indicators had failed to rally in any meaningful way. How employment lead indicators were still very weak in the US and core inflation was coming down to the low twos in a number of developed economies.
So with that said, risk assets at that time were pretty much at sky high valuation levels. Credit spreads were close to historic tights. We saw very little value in credit other than at the very short end. And we thought that bond yields had huge potential to decline and the framing for us is very much focused on the historic precedent of how bonds behave after the last rate hike.
So this is a chart that we’ve been showing people all year.
Let me talk you through it. T + 0 on the X axis is where 10-year bond yields were at the date of the last rate hike. So any move up or down on the Y axis is the change in 10-year US Treasury yields in the months after the date of the last rate hike.
In all cases going back to the late 1960s, bond yields eventually do decline materially. Following the last rate hike, however, the paths diverge and as you can see, the most recent experience has tracked the 1970s. A very frustrating path.
But as we sit here today we see bond yields starting to fall materially below where they were at the date of the last rate hike, which was about 3.9% for US Treasuries last July. As I said, we continue to to behave in a way that bonds have behaved in the past.
There is now the perception that the US Federal Reserve is behind the curve and they may have to cut by 50 basis points at their next meeting in September. We think that’s justified.
The move in the unemployment rate in July that just came out shows that that unemployment rate is already significantly above where the Fed thought it would be at the end of this year.
We see material progress on the lagging sticky bits of inflation like owners’ equivalent rent last month. And we’ve seen developed market central banks cutting in almost every other country. So the Fed is looking behind the curve. We think they will have to play catch up and a I said the historic precedent would suggest that bond yields have room to materially decline.
In the last week or so, they have come down to levels which are more consistent with where growth is trading. So we’re seeing encouraging progress on that front, but credit spreads themselves to us even with the recent move wider in the last couple of days aren’t looking particularly compelling value. The starting point as I said earlier was almost at all-time historic tights in credit spreads.
Credit has been lower beta than the moves we’ve seen in the equity market, particularly in very bubbly parts of the market like Japanese equities and US tech equities. Credit has been low beta. It has sold off in sympathy, but it’s not looking particularly compelling at the moment.
So with that being said, we sit here today with central banks across the developed world beginning to cut rates, even the Bank of England earlier this month.
We think the Fed will follow in September and they’re increasingly looking behind the curve and with that, the market regime has adjusted in an incredibly fast and ferocious manner,
The potential for much quicker and more aggressive rate cuts to start the cycle will make people reconsider the kind of investments that they’ve been focused on. So money market funds, short dated, longer credit positions obviously at risk in a market in which employment is beginning to deteriorate.
Employment is always the key catalyst for bond markets to price in a recession and we’ve seen that with a dramatic curve steepening that is associated with this bond rally in the last week or two.
So with that, I think it’s an interesting time for a lot of core bond funds which have been out of fashion in recent months or indeed in recent years. We’ve been in a four year bond bear market and history always suggested that bonds were due some outperformance post the last rate hike and as we entered rate cutting territory.
And with that, thank you for listening.
5 Aug 2024
3 minute watch
3 minute watch
Key takeaways:
- The market environment is shifting with expectations that the US Federal Reserve (Fed) has been slow to act and may have to cut rates by 50 basis points at its September meeting.
- We have been saying for several months that lead economic indicators were weakening, particularly the more critical employment data, and that central banks needed to be cutting interest rates.
- The US 10-year Treasury yield is closely following the average path of the 1970s, suggestive of deeper declines in bond yields (and rises in bond prices) ahead if the historical path is maintained.