The evolution of bond markets (and where to next)

Chasing stability amongst global uncertainty

Central banks reacted to rescue their economies from the pandemic's economic impact by cutting interest rates aggressively and launching massive bond-buying programs to inject liquidity into financial markets. These actions drove yields to historic lows in 2020. 

In Australia, 3-year bonds reached a low of 0.08% and a 10-year low of 0.61%. In other countries, negative yields appeared. At this point, the threat of inflation was not on the radar. These extremely low interest rate levels along with government fiscal stimulus measures and a vaccine brought signs of economic recovery.

These inflation concerns triggered fears of a tapering of central bank support and led to periodic volatility in bond markets, causing fluctuations in yields. Major central banks, such as the Federal Reserve, communicated their intention to maintain accommodative monetary policies despite the ‘temporary’ spikes in inflation. 

Such reassurances aimed to stabilise markets and mitigate volatility in bond yields. Inflationary pressures continued to grow as labour markets around the world tightened. This pushed wages higher, leading to a sustained and aggressive tightening of monetary policy by central banks through 2022 and 2023. Short-term interest rates in Australia are over 4% higher than in 2022, while the US Federal Reserve and other central banks have increased their cash rates by over 5%. 

As of mid-January 2024, the Australian 3-year yield sits around 3.85% and the 10-year at 4.3% having rallied sharply since the end of October as the market's attention turns to rate cuts as inflation begins to fall. These yield movements have caused bond market indices to reverse from negative returns to positive returns for calendar year 2023, following the negative bond market returns for calendar years 2021 and 2022.

A calm surface, underlying volatility

Today, the bond yield story continues to evolve. On the surface, bond markets appear to have calmed considerably, relative to the historic extreme turmoil of 2022. However, beneath the surface, bonds remain highly volatile by historical standards. 

This is due to elevated macro uncertainty, stemming from the tension between inflation versus recession risk. Despite inflation generally surprising to the upside of consensus forecasts over the last two years, markets are now pricing a forward-looking expectation that inflation, and by extension interest rates and bond yields, has peaked and will fall relatively quickly from current levels.

Where to next? From volatility suppressors to amplifiers

Any time economic growth was at risk, it was easy for central banks to justify more stimulus to quickly get things back on track, which meant they acted as a safety net or a volatility suppressor.

For portfolio construction, the result of central banks becoming volatility amplifiers, combined with inflation uncertainty, the market is now in a a regime of structurally higher bond market volatility and more variable bond versus equity correlations. This has implications for multi-asset portfolio construction.

Amid these stormy market conditions, defensive asset allocations still have an important role to play for investors. As global macroeconomics continues to shift and central bank priorities evolve, it will be important to carefully consider the role of fixed income in portfolio construction. To mitigate volatility and risk, a diversified, high-quality bond strategy that prioritises liquidity and capital preservation will be important.

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