October 2022
Although this bond bear market has been the worst he’s ever seen, Paul Brain, manager of BNY Mellon’s Global Dynamic Bond strategy, says there are glimmers of hope on the horizon.
Some think that yields will help shore up fixed income returns amid what continues to be a tough bond market, says Newton’s fixed income leader Paul Brain. While calling the 2022 bond bear market the worst in his career, the upside has been the end of the zero-interest rate environment – a return to healthier yields. This, he notes, has made the current market difficult but will also make any bond recovery, faster.
Brain notes the market up to July was beset by volatility and pressure – worse even than in 1994, the infamous period often referred to as the “great bond massacre”1 (and that was considered the worst since 19272). There are a lot of similarities today with 1994 – in both incidents the bond market sold off strongly when central banks (namely the US Federal Reserve (Fed)), fell behind the curve, suddenly raised interest rates in order to combat rising inflation.
The difference is that back then it was mainly the US that had to raise rates quickly (the first in February 1994 to 3.25%, ending the year at 5.5%3). Today economies around the world have been more aggressively raising rates to combat rapidly growing inflation, Brain says. Another difference is the starting level of interest rates. By the standards of the time, 1994 cash rates were low but nowhere near as low as they were at the start of 2022 – almost zero across most major economies. This meant that when bond prices fell in 94, the income from coupons was healthier and provided a cushion for capital losses.
The slighter coupon buffer present today has made returns in this market that much more difficult in the first half of the year, Brain says. Higher issuance in recent years, thanks to years of such accommodative policies, added fuel to this fire. Brain notes: “With greater issuance, bond indices have become far more interest rate sensitive than they once were.”
While emerging markets were raising interest rates earlier than the developed world, having more of a history of inflation problem, its hard currency sovereigns were correlated with the US, Brain adds. Brain notes while local currency emerging market debt (EMD) looked more attractive, in that area of the market it is all about credit quality and there have been big divergences. For instance, Turkey is combatting inflation of some 80% while in areas like Indonesia it slowed in August to 4.7%.4 Brain adds: “In Argentina there is the threat of default while places like Sri Lanka defaulted and Pakistan has borrowed heavily and looks vulnerable. In local currency EMD you have to be careful with your analysis and be selective.”
What’s next?
While bond bear markets tend to be short lived, Brain doesn’t think all the pain has been felt yet in this one. That said, he does think we may be in the final throes. “Bond bears can be savage but that said, they are also quick to reprice. We are already seeing an inversion of the curve, which shows a peak in rates is coming (within the next 12 months). The higher rates also mean the ability to generate total returns is easier with yields closer to 4% than the close to zero they were when this bear market began.”
This, he says, means returns from bonds and bond funds, should be able to claw back the losses from earlier this year. Although it will still take some time. “The market will need to see evidence economies are responding to the rate hikes. In July we saw some evidence the medicine was working but it will take a while to cool economies which are at full employment. Central banks are likely to need to create a recession to change the inflation narrative.”
Brain says the labor market may be key. He expects unemployment will rise in the coming months as companies adjust to the changing macro backdrop. With financing more expensive, rising costs and employees seeking higher wages, for companies to survive Brain believes layoffs may be inevitable. In this environment, Brain expects credit defaults may pick up.
1 CNN Money, citing Fortune Magazine. October 17, 1994.
2 The Washington Post. For bond investors, 1994 was a year to forget. January 1, 1995.
3 MoneyWeek. Here’s what happened the last time the bond market crashed. October 2018.
4 Tradingeconomics.com. As of August 2022.
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