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Base case of churn and earn, with symmetrical risks around bull case

By Robert Tipp
4 minute read

Most bond market participants were ready for the bear market to end a year ago. In terms of total return, one could make the case that it did: many bond market total return indices are above their 2022 lows, if only slightly, yet higher risk fixed income sectors have chalked up substantial gains.

However, in terms of yield, the market churn of Q3 pushed yields to new highs, begging the questions: are we still in a transition to a new bull market, and if not, how far along is the bear market?

By the time the 20 September Fed meeting came around, the 10-year Treasury yield had notched up to 4.35 per cent – last year’s cycle highs. Like so many times this cycle, investors who were expecting a dovish pivot were caught offside, and renewed selling pushed US yields to fresh cycle highs in the 4.60 per cent area as the quarter drew to a close, and they proceeded to nearly reach 4.90 per cent following the September payroll report. Yet while most major developed market yields also scratched new cycle highs by narrow margins during Q3’s market churn, not so in Japan, where the 10-year JGB yield jumped a decisive 25 bps to 75 bps as Q4 started.

At this point, the main forces pushing the yield curve higher are the central banks and a heavy supply of government bond issuance. Upward momentum in long-dated yields could easily push 10-year Treasury yields beyond 5 per cent if fundamentals heat up again.

In addition to the Fed and supply, other risks are on the horizon – with geopolitics, volatile energy prices, and emboldened labour unions topping the list. But the overarching economic backdrop appears to be turning more bond friendly. Purchasing manager surveys have moderated across DM for several quarters and inflation looks like it is beginning its descent towards target.

Given the DM world’s flat or inverted curves, at least for the near term, government bond returns may only be in the realm of cash in the quarters ahead. However, bonds remain attractive for five reasons.

The first is alpha generation – the past year of tumult has offered opportunities for adding value in all areas of fixed income: term structure positioning, sector allocation, local EM rates, and even FX. Second, credit product performance has been positive ever since the central banks abandoned their outsized rate hikes – a trend we generally expect to continue, which should benefit diversified fixed income portfolios.

Third, long-term income hedge – if past is prologue, an unexpected shock or economic moderation will eventually take short rates down. In that event, those who opted for cash and failed to lock in higher rates at the peak of the rate cycle will end up losing out in the long run. Fourth, in a risk off event, government yields may fall, providing ballast in portfolios.

Lastly, the relative valuations look compelling. Although bonds have repriced post-COVID-19 and yields are back to respectable levels, equities have not, and, therefore, some would argue they look expensive by comparison, leaving stocks vulnerable to a repricing due to either economic or interest-rate risk.

Our base case envisions bullish market fundamentals continuing to develop as they have in recent months, coming to the fore as a market driver as we move towards and into 2024. Major central banks are on the precipice of an inflection point – for the Fed, that may mean 50–75 bps of rate cuts in 2024 from the current Fed funds midpoint of 5.375 per cent.

In other words, just as central banks are reiterating their conviction to remain higher for longer – and to maintain higher nominal and real rates than previously envisioned – the economic data has begun to moderate. This suggests that rate hiking cycles are close to, if not at, their peaks and this bodes well for the bond market outlook with a broad range of fixed income products appearing well positioned for solid risk adjusted returns on both an absolute and relative basis.

This forecast for the bond market remains consistent with the formula for returns we put forth at the end of 2022: yields are back up at respectable levels, and we expect them to stay roughly around current levels for the long run. This should allow bonds to earn their yield in the years ahead, albeit with intermittent volatility – churn and earn.

Robert Tipp, managing director, chief investment strategist, and head of global bonds, PGIM Fixed Income