The writer is chief market strategist for EMEA at JPMorgan Asset Management
For the first time in over a decade I’m starting to get excited about Bonds. This represented a major shift in my enthusiasm. For years, I felt the bond market was horribly mispriced.
Not more than it was at the beginning of this year. Inflation was on the rise, central banks were still blindly assuming it was temporary and governments seemingly lost their fear of debt. However, the 10-year government bond yield is 1 per cent in the UK, 1.5 per cent in the US, and a staggering 0.2 per cent in Germany.
The price of corporate bonds was similarly puzzling. Investment-rated companies have generally offered a fraction of the additional yield above ridiculously low levels in government bond markets. With yields of around 3 percent in Europe, the term “high-yield bond” was, frankly, laughable. In fact, at some point, a third of the bonds in the Barclays Global Composite Index had a negative yield and the term “fixed income” seemed an oxymoron.
The problem was that investors and central bankers had wholeheartedly bought into the “lower for longer” narrative and the idea that inflation and growth were permanently low for structural reasons. A consensus has formed that growth will always be lackluster due to weak demographics and productivity. This inflation will forever be constrained by forces such as globalization and the Internet. It was assumed that central banks would have no choice but to keep interest rates low in their futile pursuit of 2 per cent inflation.
The absence of inflation also led to the assumption that central banks would always be able to buy bonds to prevent periods of financial volatility. Investors have stopped demanding so much of the risk premium, knowing that central banks will take assets out of their hands if times are tough.
This has all been proven wrong. It is now quite clear that the economies of the developed world can produce inflation. And not just because it will be subject to cost shocks – we can generate inflation locally.
Former US Federal Reserve Chairman and recent Nobel laureate Ben Bernanke has finally announced his “chopper” theory. This term is taken from great talk delivered in 2002. In this speech, he not only used (in my opinion) the underutilized term “voluntarily”, but also argued “that under a fiat money system, a determined government can always generate higher spending and hence positive inflation” . We now know that this is true.
The bond market It has undergone a brutal repricing. Markets have had to completely rethink the price outlook for central bank policy and the risk premium that must exist in a world where central banks cannot support the market.
Some might argue that the recent BoE interventions in the gold market show that the central bank’s “float” is still there. But the bank stressed that this support is time-limited, and for its inflation-related mandate, it will have to return to its plans to trim its balance sheet next month. The new risk premium remains. UK 30-year government bonds are more than 3 percentage points higher than they were at the start of the year.
The correction in global bond markets, while painful, is nearing completion. In all likelihood, we are not returning to a period of very low growth or inflation, nor are we entering a sustainable period in which inflation is spiraling out of control.
In the coming months, led by the US first, inflation is likely to ease in response to weaker activity. But I don’t expect the economy to collapse, proving that it can afford slightly higher interest rates than it has in the past. The 10-year US Treasury yield should be 4 percent in my view, a level the market broke through at the end of last month.
If I’m right, global bond prices are starting to look really attractive. Just look at the amount of modification we’ve seen. The global government bond standard now yields 3 percent compared to 1 percent at the beginning of the year, global investment grade now has a return of more than 5 percent versus less than 2 percent and global high yield again deserves such a title with a return Nearly 10 per cent.
“No pain, no gain” is a depressing saying when it comes to getting fitter as it is with bonds. But after the pain of 2022, there is room for good gains ahead.