The market’s attention remains on interest rates and the policy choices of central banks. Bond markets, therefore, are increasingly ignored.
Central banks around the world have found themselves faced with one of the most significant economic challenges of recent decades: managing the balance between high interest rates to contain inflation and the growing pressure to stimulate economic activity in a context of global economic uncertainty (the so-called "soft landing"). This situation has raised questions among investors about how long central banks will maintain high interest rates and what that means for their portfolio strategies, with particular reference to the bond market.
Inflation and central bank policy
Inflation has been on every major headline in the past few years, with prices rising significantly in many economies. This situation has pushed central banks to review their monetary policies in order to avoid an uncontrollable inflationary spiral. To do so, they increased interest rates and reduced or ended asset purchase programs, such as bonds and stocks, that had been launched during the pandemic.
However, the decision to keep rates high is not without its challenges. Raising rates too quickly could slow economic growth and increase the cost of borrowing for businesses and consumers, which could have negative effects on employment and the economy as a whole.
Over the past decade, investors have operated in a steadily declining interest rate environment. This trend has been accentuated since 2009, when both the American Federal Reserve and the European Central Bank brought interest rates to historic lows, almost to zero, and in some cases even into negative territory for government bond yields.
This long phase of low interest rates shaped the expectations of market participants, who are now wondering when central banks will start lowering rates. However, central banks may not consider reducing rates at all, as argued by Gita Gopinath, the first deputy managing director of the International Monetary Fund, who stated that rates could actually remain high for an extended period.
This perspective represents an interesting but contradictory point of view compared to the expectations of the market, which continues to price the hypothesis of a future reduction in rates in stock market valuations.
The IMF timidly forecasts that central banks will go to great lengths in order to keep inflation under control, avoiding a possible new wave of price increases, as happened in the 1970s.
Similarly, recent economic data has begun to show the first signs of trouble in the United States as well. The negative surprise in the jobs data, with lower-than-expected job growth in the ADP report and a similar report in the JOLTs, indicates that the labor market is experiencing a slowdown.
Currently, the stock market reacts ambivalently to these considerations: sometimes it interprets bad news as good, hoping for a reduction in interest rates that would reduce the cost of debt for listed companies, but sometimes it remembers that worsening economic conditions may result from a contraction in citizens’ consumption, which would hamper businesses’ growth.
What implications for the bond world?
The bond market is one of the most sensitive sectors to central bank policies, as interest rates directly influence bond yields. When central banks raise rates, bond yields tend to rise, reducing the value of existing bonds.
However, not all bonds are created equal. Short-term bonds tend to be less sensitive to changes in rates than long-term bonds. At the same time, the return-risk parallelism becomes relevant: Interest rates that are raised too quickly greatly increase the risk of holding onto a bond. This is because the chances of the company or country being able to maintain faith in their debts are linked. It is no coincidence that, according to some experts, especially in corporate bonds, returns do not yet perfectly reflect the risk and by 2025 the default rate of the so-called fallen angels could increase. The same, but in a less marked way, could apply to government bonds, which are also strictly dependent on the trend of the interest rate and the risk of default of the country, but often priced incorrectly by the market, which weighs short-term expectations poorly.
In summary, the duration of central banks’ high interest rate policy remains an open question and will depend on a number of economic factors, including inflation and economic growth. Investors should continue to closely monitor central bank statements and actions and make informed investment decisions based on market conditions, considering short-term market expectations as a valid guide for long-term investment decisions.
Original article published on Money.it Italy 2023-09-05 16:30:00. Original title: Le obbligazioni già sanno cosa faranno le banche centrali
