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).

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