(Bloomberg) — A few brave souls in the investing world are starting to move back into bonds to ride out an oncoming economic storm.
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While debt bulls on Wall Street have been crushed all year, market sentiment has shifted markedly over the past week from inflation fears to growth.
Market-derived expectations of US price growth dropped from multi-year highs while nominal yields in the US, Germany, Italy and UK retreated. At the same time a report showing higher than expected price increases for American consumers failed to ignite a sustained rout — a sign of bear-market exhaustion after a historically bad start to the year.
With inflation pressures still rampant everywhere, no one is betting with conviction that yields in any of the world’s major markets have peaked. But the argument goes that the asset class still offers a powerful hedge as the Federal Reserve’s aggressive tightening campaign threatens to spur a downturn in the business cycle that could ripple across global assets.
“We just started buying Treasuries,” said Mark Holman, a partner at TwentyFour Asset Management, a London-based investment firm that specializes in fixed-income securities. “I’m quite pleased that Treasury yields have gone up so much, because I know we are going to need them because we are late cycle.”
Developed stock and credit markets have fallen this month with economically sensitive trades in the line of fire, helping spur the biggest Treasury inflow since March 2020. While bunds have rallied sharply of late, they look more vulnerable given the European Central Bank’s tightening campaign has yet to kick in. But that’s not stopping the likes of Citigroup Inc. strategists seeing a reversal in the bund selloff for now as global growth concern trumps elevated inflation expectations.
“Government bonds can begin to offset risks elsewhere,” said Howard Cunningham, a fixed income manager at BNY Mellon Investment Management. “We’re not betting that the rise in yields is going to reverse, but government bonds can begin to do a job. Now, you’ve got negative correlation with equities some of the time.”
US government bonds have already lost 8.4% this year through Thursday, putting them on course for their first back-to-back annual declines in at least five decades, according to a Bloomberg index. A global gauge is down 12%. Yet the 10-year Treasury yield has fallen almost 30 basis points since hitting 3.20% on May 9, its highest since 2018. At the same time stocks have dropped sharply amid fears over growth, exacerbated by the war in Ukraine and Covid lockdowns in China.
A look under the hood of the derivatives market suggests hedge funds are now unwinding bearish Treasury exposures and fueling yields lower.
European Lag
Candriam and AXA Investment Managers are among the firms that see US debt as a better bet than bunds for now. The market-implied expectations suggest the Fed will start cutting rates as soon as 2024, after lifting the funds rate to just over 3% next year.
“We are starting to think about buying Treasuries,” said Nicolas Forest, head of global fixed income at Candriam. “US yields are more fairly priced because the hiking cycle is already taking place. We are definitely lagging in Europe.” The German two-year yield, around 0.11% on Friday, is “too low” given the deposit rate may be 0.25% by year-end, he added.
The European Central Bank is only expected to start raising rates in July and traders don’t see cuts for at least the next four years. On this trajectory, U.S. bond prices would get a meaningful boost through a Fed easing cycle at a time when bunds face the headwind of tighter monetary policy.
Pulling Ahead
But things aren’t so clear cut. To Mark Healy, a portfolio manager at AXA Investment Managers, the UK looks like a relatively safe place to be right now, given the Bank of England’s tightening campaign is in swing, but bonds in the euro area may yet offer opportunities.
“We’d favor the UK the most, then the US and then Europe, even though we’d probably push back a bit in terms of how many ECB hikes are priced in,” said Healy. “So further down the road, European government bonds could offer value.”
Still, investors are united in their cautious stance on Italian debt right now. BNY IM recently increased a short in BTP futures as the ECB phases out the easy-money era, while BNP Paribas SA advised against a long position.
Meanwhile Deutsche Bank AG’s Gary Pollack warns the Treasury selloff isn’t over given persistent price pressures from rental costs to airline fares.
“While we expect inflation to fall, the question is will markets be happy where it settles down to?” said the head of fixed income for private wealth management. “That’s why I’m a little reluctant to say let’s buy here.”
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