As rates fall, is the diversifying power of bonds rising?

The bond market, particularly the long-term bond market, has regained momentum. With the spectre of inflation diminishing, the Federal Reserve’s (Fed’s) attention is turning to employment. Does this indicate an economic slowdown is on the way, and could the anticipation of a downturn drive rates even lower? Many hope so.

To gauge the extent of this potential decline, investors need to answer the following question: if rates do fall, will it be due to a reduction in real rates or inflation? This distinction could be crucial for portfolio allocation decisions at the end of the year. This week, Simply put considers what happens to rates at the end of a cycle.

What happens at the end of the cycle?

It’s a common assumption that, as a cycle ends, rates generally start to fall as large investors shift allocations from equities to bonds. The decline in equities contributes to the fall in rates, as it is generally driven by a deterioration in corporate-earnings outlooks. While this phenomenon is well-known to asset allocators, as Irving Fisher comprehensively explained in 1930, rates can fall for two distinct reasons: nominal rates can be broken down into real rates and expected inflation. When Fisher’s book,  “The Theory of Interest”, was published, there was no market for expected inflation. But since the late 1990s, this has changed in several countries or regions.

Today, we can explore not only the trajectory of nominal rates during recent slowdowns but also their decomposition. Figure 1 compares the two components that make up US 10-year Treasury rates against the backdrop of our nowcasting US growth indicator. The graph clearly shows that if rates fall when our growth index declines, it is primarily due to a decrease in the inflation premium. As for real rates, they tend to rise instead of fall during these periods.

The year 2020 was exceptional in this regard: real rates did not rise during the Covid pandemic, largely because the Fed intervened significantly to prevent rate increases following the announcement of the Trump administration's first fiscal stimulus package. Downturns caused by shocks like the pandemic are usually accompanied by fiscal stimulus programmes, which is one of the reasons why real rates rise during such events: the government absorbs capital to finance the stimulus, thereby driving up the cost of capital. This crowding-out effect is well-known among economists. So, has this phenomenon occurred only in the US?

FIG 1. 10-year real rates and 10-year expected inflation vs LOIM growth nowcaster index

Source: Bloomberg, LOIM. As of 12 September 2024. For illustrative purposes only.
 

Falling inflation, rising real rates

In truth, we significantly lack the observations needed to validate the point we identified in the previous paragraph. While the 2008 slowdown indeed saw real rates rise and inflation expectations plummet, the effect was weaker in 2000 and non-existent in 2020. Although there are likely sound reasons for these differences, we can compensate for the lack of time-series data by analysing these scenarios in different countries. We attempt to illustrate this in Figure 2.

The charts show the average real rates and average inflation premium per level of our country-specific nowcasting indicators for the US (already described), Japan and the UK. The empirical conclusion appears to hold up against this geographical analysis: the slowdowns in the domestic cycles, as measured by our indicators, typically lead to a decline in the inflation premium but an increase in real rates. This effect is surprisingly consistent across these countries.

This conclusion is particularly significant at this stage of the cycle, since we have considerably modified our bond allocation. If rates fall in the coming weeks and months, it is more likely to be due to a contraction in expected inflation than to a contraction in real rates. As we discussed last week, real rates may well decrease by some 25 basis points, but expected inflation could easily drop by about 100 bps in the event of a cyclical crash (over 10 years in the US). This bodes well for the diversifying power of bonds.

FIG 2. US, Japanese and UK expected 10-year inflation and 10-year real rates as a function of LOIM growth nowcasting indicators (1999-2024)

Source: Bloomberg, LOIM. As of 12 September 2024. For illustrative purposes only.

What this means for All Roads

The recent pivot in our All Roads allocations towards bonds aligns with the enhanced diversifying power of bond investments in the current environment. Volatile periods from early August onwards have demonstrated just how effectively bonds can protect portfolios against cyclical uncertainties. More than half of the All Roads portfolios now consists of hedging assets, including bonds and volatility strategies. History shows that such increased diversification – without abandoning cyclical assets – has often been rewarded in the weeks leading up to a US election, as we detailed previously. At this stage of the cycle, caution is synonymous with diversification, not disinvestment.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Despite numerous economic data releases, our nowcasting growth indicators have remained notably unchanged, continuing to signal slowing activity
• Our inflation indicators are currently in the neutral zone but continue to show an upward trend: 62% of the data collected indicate rising inflationary pressures
• Our monetary policy indicators suggest that both the Fed and the European Central Bank are poised to favour short-term rate cuts

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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