Yields are at their highest level since 2008, inflationary pressures are easing, and interest rates could fall in the year ahead. However, markets may have become excessively optimistic about the timing and scale of rate cuts, which could disrupt investors’ benign view of bonds in the near-term.
From November onwards, fixed income markets started to price in significant interest rate cuts in the year ahead. The US 10 year treasury yield dropped from 4.7% to a low of 3.8% against a US Fed funds rate of 5.25-5.5%. Partly, this expectation has been driven by the Federal Reserve’s own forecasts, which suggest three rate cuts in 2024.
Yields have moved a little higher since the start of the year as inflation readings have come in ahead of expectations. However, the US 10 year treasury yield has only moved to 4.1%, still significantly below its peak in late October. This optimism on interest rate cuts has been the galvanising force behind the equity market rally.
Substantial progress has been made on inflation over the past 12 months. US CPI has dropped from over 6% in January 2023 to 3.4% today, with similar falls seen in Europe and the UK. We are broadly confident that central banks have been successful in fighting off runaway inflation and, through elevated interest rates, have been able to better anchor long-term inflation expectations. However, it doesn’t mean inflationary pressures have disappeared altogether.
Rolling geopolitical crises have created pressures in commodities pricing, for example. Should the Israeli/Gaza conflict spread to other countries in the region, it could see oil prices spike higher. At the same time, the Houthi presence in the Red Sea threatens to raise shipping costs and extend lead times. The Ukraine/Russia conflict continues to disrupt commodity supplies, and there is also growing competition for the commodities needed to support the energy transition. This all creates an inflationary headache.
In the meantime, other pressures remain. The US consumer price index increased 0.3% in December over November, a rise of 3.4% from a year ago. The major culprit was rises in shelter costs, which rose 0.5% month on month and impacted core inflation.
In the UK, services inflation is proving persistent. A large element of core inflation, its strength has kept inflation higher and continues to trouble the Bank of England. For the Bank of England to be comfortable cutting interest rates – which in turn will bring down mortgage rates and potentially put more money into people’s pockets – it has made it clear it wants to see services inflation ease.
Against this backdrop, central banks may err on the side of caution and keep rates higher for longer, in spite of rising recessionary signals.
Having racked up significant spending during the pandemic, Western governments are facing significant debt burdens. The US national debt is currently sitting at nearly $33 trillion dollars, up almost 90% since the start of the pandemic. It is now nearly 100% of GDP. The annual fiscal deficit was $1.7 trillion in the year to September 2023, the third-worst number on record, while the annualised interest bill has hit $1 trillion, or 20% of tax income.
The US figures are particularly eye-watering, but the UK and European governments are in a similarly precarious situation. These high debt levels have an impact on issuance – governments must issue more debt to maintain current public spending levels, or have a difficult conversation with their electorates. Few are minded to have this conversation in a busy year for voting. Certainly, in the US, neither side appears interested in tackling the deficit, with the Republicans looking to cut taxes and the Democrats to raise spending.
This high issuance is happening at a time when central banks are trying to wind down their balance sheets. That means more government debt is being bought by market sensitive buyers, who might demand higher yields if credit worthiness deteriorates. This remains a major risk across developed government bond markets.
After a strong year in 2023, corporate bond spreads over government bonds are now at their lowest level in two years. At the same time, signs of distress are starting to emerge at the sidelines. A report by Moody’s showed global corporate defaults surging in December. The global 12-month trailing corporate default rate rose to 4.8%, the highest rate since the year to May 2021 (which included the impact of some pandemic-related bankruptcies). Moody’s attributed the rise to, “high funding costs, together with tighter financing conditions.”
This suggests that some spread widening is plausible in the months ahead. While high government bond yields provide a cushion, credit selection is likely to become increasingly important.
Our view is that the Federal Reserve, European Central Bank and Bank of England will keep monetary policy tight next year, despite recent optimistic market pricing calling for early 2024 rate cuts. We believe rates have peaked, but a pivot in policy at major central banks is only likely if a number of conditions are met: we would need to see core inflation around the low 3% levels with a strong probability that inflation will continue its path to the 2% target level. Labour markets need to weaken, which would lead to a slowdown in consumption.
Bond markets may have got ahead of themselves in the short-term. While rate cuts remain a possibility for the year ahead, they may not be as sure a bet as the market currently believes. Bonds remain a compelling diversifier, but high expectations could create some volatility, which in turn may disrupt the view that fixed income is the golden ticket for 2024.
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