Stick to your bonds

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we consider whether the rising risk of a monetary policy mistake is altering the investment case for bonds.

 

Need to know Inflation is now more than double the Federal Reserve and the European Central Bank’s targets, putting their actions at centre stage. Despite the perception, monetary policy tightening is not necessarily a negative for bonds. As with an increasing risk of a monetary policy mistake, the risk-reward profile of bonds looks much better today than it was a year ago.

 

What was initially thought of as a transitory supply chain issue was in fact a demand shock caused by excess fiscal stimulus, originally meant to support the pandemic’s drawdown.  As a result, US CPI reached 7% YoY and Eurozone inflation reached 5%, both of which are more than double their respective central bank targets. Central banks are preparing themselves to increase rates as demand-driven inflation – unlike supply-side driven inflation – falls under their explicit mandate. Inflation is no longer an economic issue but has become of a political one due to its impact on the average consumer’s pocket. Central banks are now centre stage. Yet should bond investors be concerned by these rate hikes? In our view, the answer is yes, in the short term, but no if the investment horizon is medium term. Here is why.

Many view tighter monetary policy as being a nail in the coffin for bond performance. However, investors would be well advised to review this.  when truncating history between monetary policy surprises and inflation shocks it is in fact inflation that is a cause for concern – not necessarily Federal Reserve surprises! Chart 1 illustrates the Sharpe ratio of different asset classes during these two different scenarios. An inflation shock forces rates to rise in order to adapt to the new inflation regime. 2021 is a perfect example: we experienced an inflation shock and bonds performed poorly over the year. Conversely, during periods of monetary policy surprise, bond performance is usually more positive. By hiking rates, the central bank curbs the trajectory of the inflation premium and eventually real rates go down.

 

Chart 1. Sharpe ratio for different asset classes during inflation shocks and monetary policy surprises 

Source: Bloomberg 2022, LOIM

However, what is unusual about today’s environment is that real rates are not decreasing but increasing. Savings are no longer progressing as quickly as nominal GDP, an effect that is being amplified by the fact that inflation has progressed faster than salaries – meaning savings are being used by consumers to temporarily maintain their standard of living. As a consequence, the stock of available money to finance investment has stopped increasing and real rates are rising. So where do we go from here?
Chart 2 represents what would constitute nominal rates under various scenarios. Today, the inflation premium is at 2.4% and real rates are equal to -0.45% putting nominal rates at 1.95%. From there, we see either a real rate normalisation; an accelerated real rates normalisation or a monetary policy mistake as three potential scenarios. 

• Real rate normalisation: real rates could normalise to 0% by year-end as savings continue to be pushed down by inflation while investment recovers. In nominal terms, rates found their lowest point in 2020 at 0.50%. Since then, investors have already experienced a 1.5% increase which has cost them an estimated 12% loss accounting for approximately eight years of duration. This additional increase in rates should cost some money for bonds holders but should also be cushioned by their reconstituted carry. 
• Accelerated real rates normalisation: real rates could increase to 1% instead of 0% as inflation stabilises faster than expected and the economy bounces back strongly as the risk of a recession is kept at bay. In his scenario, equity gains should more than make up for the losses incurred by bonds.
• Monetary policy mistake: Central banks may tighten too fast, too soon and push the economy into a recession. 

Chart 2. Nominal rate level under different scenarios

Source: Bloomberg 2022, LOIM

In our view, the first scenario is most likely. However, the risk of a monetary policy mistake has increased significantly compared to last year as central banks finally embark on their tightening journey. In that scenario, bonds will be a welcome hedge to any multi-asset portfolio. This means selling bonds today would be the same as getting rid of your put close to its strike price – our expectations for the fixed income world past this current normalisation has clearly improved.

Simply put, keep your bond exposure as the risk of a monetary policy mistake is increasing. It’s better to be safe than sorry.

 

Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick.

These indicators currently point to:

• Solid growth worldwide, with stronger momentum in the Eurozone, while China lags. Recently, Chinese macro data has increasingly pointed towards a stabilisation.
• Inflation surprises are retreating as the strength of demand slows and the growth of input prices moderates.
• Monetary policy is set to remain on the hawkish side, except in China. The necessity for hawkish monetary policy is retreating, as per the decline in our indicator.

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).

À l’usage des investisseurs professionnels uniquement
Le présent document a été publié par Lombard Odier Funds (Europe) S.A., société anonyme (SA) de droit luxembourgeois, ayant son siège social sis 291, route d’Arlon, 1150 Luxembourg, agréée et réglementée par la CSSF en tant que Société de gestion au sens de la directive 2009/65/CE, telle que modifiée, et au sens de la directive 2011/61/UE sur les gestionnaires de fonds d’investissement alternatifs (directive GFIA). La Société de gestion a pour objet la création, la promotion, l’administration, la gestion et la commercialisation d’OPCVM luxembourgeois et étrangers, de fonds d’investissement alternatifs (« FIA ») et d’autres fonds réglementés, d’organismes de placement collectif ou d’autres véhicules d’investissement, ainsi que l’offre de services de gestion de portefeuille et de conseil en investissement.
Lombard Odier Investment Managers (« LOIM ») est un nom commercial.
Ce document est fourni à titre d’information uniquement et ne constitue pas une offre ou une recommandation d’acquérir ou de vendre un titre ou un service quelconque. Il n’est pas destiné à être distribué, publié ou utilisé dans une quelconque juridiction où une telle distribution, publication ou utilisation serait illégale. Ce document ne contient pas de recommandations ou de conseils personnalisés et n’est pas destiné à remplacer un quelconque conseil professionnel sur l’investissement dans des produits financiers. Avant de conclure une transaction, l’investisseur doit examiner avec soin si celle-ci est adaptée à sa situation personnelle et, si besoin, obtenir des conseils professionnels indépendants au sujet des risques, ainsi que des conséquences juridiques, réglementaires, financières, fiscales ou comptables. Ce document est la propriété de LOIM et est adressé à son destinataire pour son usage personnel exclusivement. Il ne peut être reproduit (en totalité ou en partie), transmis, modifié ou utilisé dans un autre but sans l’accord écrit préalable de LOIM. Ce document contient les opinions de LOIM, à la date de publication.
Ni ce document ni aucune copie de ce dernier ne peuvent être envoyés, emmenés ou distribués aux États-Unis, dans l’un de leurs territoires, possessions ou zones soumises à leur juridiction, ni à une personne américaine ou dans l’intérêt d’une telle personne. À cet effet, l’expression « Personne américaine » désigne tout citoyen, ressortissant ou résident des États-Unis d’Amérique, toute association organisée ou existant dans tout État, territoire ou possession des États-Unis d’Amérique, toute société organisée en vertu des lois des États-Unis ou d’un État, d’un territoire ou d’une possession des États-Unis, ou toute succession ou trust soumis dont le revenu est imposable aux États-Unis, qu’en soit l’origine.
Source des chiffres : sauf mention contraire, les chiffres sont fournis par LOIM.
Bien que certaines informations aient été obtenues auprès de sources publiques réputées fiables, sans vérification indépendante, nous ne pouvons garantir leur exactitude ni l’exhaustivité de toutes les informations disponibles auprès de sources publiques.
Les avis et opinions sont exprimés à titre indicatif uniquement et ne constituent pas une recommandation de LOIM pour l’achat, la vente ou la détention de quelque titre que ce soit. Les avis et opinions sont donnés en date de cette présentation et sont susceptibles de changer. Ils ne devraient pas être interprétés comme des conseils en investissement.
Aucune partie de ce document ne saurait être (i) copiée, photocopiée ou reproduite sous quelque forme et par quelque moyen que ce soit, ou (ii) distribuée à toute personne autre qu’un employé, cadre, administrateur ou agent autorisé du destinataire sans l’accord préalable de Lombard Odier Funds (Europe) S.A. Au Luxembourg, ce document est utilisé à des fins marketing et a été approuvé par Lombard Odier Funds (Europe) S.A., qui est autorisée et réglementée par la CSSF.
© 2022 Lombard Odier IM. Tous droits réservés.