Bond prices have risen sharply over the past month or so, driven mainly by central banks signalling that interest rates have peaked, and while that view may be slightly optimistic, “it shouldn’t put investors off fixed income”, says Chris Iggo, chief investment officer for core investments at Axa Investment Managers.
He says that despite the markets’ increased certainty around the direction of monetary policy: “Cool-headed analysis suggests the cat-and-mouse game between bond investors and central banks will continue. Despite the lower-than-expected outcomes for inflation in October, inflation remains higher than desired.
“In addition, growth data is not yet weak enough to really squeeze inflation back to central bank target levels. In fact, despite the rally in long-term bonds, rate expectations have only fallen modestly. The end-2024 expectation for the Fed Funds Rate, derived from the Fed Funds futures market, is still at 4.35 per cent compared with 4.8 per cent in mid-October,” Iggo continues.
“Similar market pricing for the [European Central Bank] and [the Bank of England] shows an unchanged picture for the former and slightly higher expectation of more easing from the latter. Rate cuts: yes, but not early in the year and only partially reversing the hikes seen in the past two years.”
However, Iggo says increased exposure to bonds remains prudent in the present climate as a consequence of the higher yields on offer at the same time as demand from buyers remains robust.
He adds that this supply and demand dynamic is particularly positive in the corporate bond universe.
Rates have peaked?
Zurich chief market strategist and head of macroeconomics Guy Miller says: “There is no doubt that the market now thinks we have reached peak rates, after many false dawns. What seems to have changed this time is that we have seen meaningful drops in both headline and core inflation.
“Previously, the market feared that core inflation would remain persistently high and this would have an impact on the direction of interest rates. This has created lower bond yields and right now that is helping bond prices but also boosting equity valuations.”
Miller believes that a recession is very likely in the UK and the EU, and is possible in the US. In such a scenario, he says: “There would start to be a disconnect between the bond and equity market rallies. I think we are in for a material economic downturn.”
In that scenario, he believes that government bond yields could come down as investors begin to expect that interest rates will be cut to stimulate growth.
Such a scenario may mean bond investors price in rate cuts before they happen, leaving returns at the mercy of central banks.
Miller says that while bond prices would be expected to rise in such a scenario, equity valuations would suffer.
While government bond prices rising would be expected at times of economic downturn, he is cautious on the outlook for high-yield bonds, as he feels that the yields currently offered by this part of the market — where the bonds have a credit rating of below triple B — are not sufficiently higher than those offered on government bonds to justify the extra credit risk.
