Will the rates rally continue?

The following is an extract from our Q1 Asset Allocation outlook.

The mid-single-digit returns[1] from global government bonds in 2023 is scant comfort to investors who have seen underperformance in real terms of 25-40%, depending on the index, since mid-2020.[2]

Looking ahead, we think there are three good reasons to expect performance to finally turn around:

First and foremost, real yields on government bonds are now back above zero. We can see that looking at inflation-linked debt: despite the Q4 rally, the yield on 10-year TIPS (Treasury Inflation-Protected Securities) in the US is still close to 2%, from a trough of below -1%. We can see the same looking at nominal yields relative to central bank objectives. In the UK, for example, 10-year nominal gilt yields are currently over 150 basis points (bps) above the Bank of England’s inflation target, having been nearly 200bps below that target three years ago.[3]

Second, the soft growth backdrop is starting to loosen labour market conditions: across the Western world, the number of people who are unemployed is rising relative to the number of job vacancies. That is a precondition for wage growth moderation and could precipitate a broader economic downturn.

Thirdly, inflation itself looks to be on a firmly downward trajectory, implying an end to the rate-hiking cycle that has dominated pricing in recent years. According to the New York Federal Reserve, global supply chain pressures have swung from the tightest conditions in a generation in mid-2021 to the loosest.[4]

There are three major risks to this outlook:

Geopolitical concerns: Escalating tensions in the Middle East could pose a threat to the smooth transit of freight through the region. More seriously, a Chinese naval blockade of Taiwan would reignite worries about shortages, especially in the electronics industry.

Economic resilience: We see sluggish growth, with elevated risks of a recession in the year ahead. If a recession doesn’t materialise until 2025 or later, we would expect the rate cuts currently priced into the front end of the US/UK/European curves to partially disappear.

Government bond supply: When we take account of the unwind in central bank portfolios, G7 governments are set to issue in excess of $3 trillion of net new debt for a second consecutive year. Unlike in 2023, there is unlikely to be an outright fiscal impulse supporting growth. However, the weight of issuance could put upward pressure on yields.

Positive real returns in 2024 would be a fillip for bond investors and continue the recovery from the real drawdown of nearly 40% seen in 2022/23.[5] But it is a low bar to meet when cash also yields 5%.

We believe that yields are set to fall enough to deliver a capital gain to investors as well, but that becomes a harder argument to make if US and UK 10-year yields drop back below 3.5%.

The above is an extract from our Q1 Asset Allocation outlook.

[1] Source: The Bloomberg Global Treasury Index, GBP hedged, returned 5.8% in 2023. As at 31 December 2023

[2] Source: Bloomberg Global Treasury Index, FTSE Actuaries UK Conventional Gilts All Stocks Index, Bloomberg LP, as at 31 December 2023

[3] UK gilt yields were 3.53% at year-end (source: Bloomberg LP), relative to the Bank of England's inflation target of 2% (source: BoE), as at 31 December 2023.

[4] Source: https://www.newyorkfed.org/medialibrary/media/markets/survey/2023/sep-2023-smp-results.pdf

[5] Source: Bloomberg Global Treasury Index, FTSE Actuaries UK Conventional Gilts All Stocks Index, Bloomberg LP, as at 31 December 2023