Authors: Soo Boo Cheah, MBA, CFA, Senior Portfolio Manager, RBC Global Asset Management (UK) Ltd.; Joanne Lee, MFin, CFA, Senior Portfolio Manager, RBC Global Asset Management Inc.; Taylor Self, MBA, CFA, Portfolio Manager, RBC Global Asset Management Inc.
After a bright start to the year, government bonds have been coming under pressure from rising yields, as economic growth and inflation are proving much more resilient than expected. In response, central banks are likely to continue hiking interest rates through at least the middle of this year to cool still-too-high inflation and a remarkably strong labour market. That said, we expect central banks to hike policy rates much less than they did in 2022. The economy has shifted down a gear, and price rises are less rapid. We expect that inflation will slow towards 2% through the medium term and therefore believe that yields today compensate investors generously. Even with further increases in policy rates and a string of recent U.S. bank failures, we expect mid-single digit returns from government bonds over the next 12 months, as the highest yields in over a decade should provide a buffer against losses.
The U.S. recently experienced its largest bank run since 2008 – with Silicon Valley Bank (SVB) entering receivership. In response, investors flocked to the relative safety of government bonds, driving down yields. We do not believe that SVB’s failure portends a system-wide crisis as policymakers responded quickly to avoid contagion risks. Moreover, the nature of the events so far differ considerably from the catastrophic losses of 2008, when the major concern was the quality of the banking industry’s assets. In SVB’s case, the problems were rooted in U.S. government bonds – assets of the highest quality whose values were hit by rising interest rates rather than any real risk that the debts wouldn’t be repaid.
We are reasonably confident that 2023 will not mark a third straight year of negative returns for bonds. One reason is that yields are much higher. Last year’s fixed-income returns were particularly poor due in part to the rapid and unexpected rise in interest rates that could not be offset by low starting yields.
The effect of higher yields is particularly notable on short-maturity bonds: investors in a newly issued 2-year Treasury bond would experience losses over a one-year holding period only if the yield on the security more than doubled to 10.0% from the current 4.8%.
The market expects 50 to 75 basis points of hikes over the next 12 months from most central banks, a stark contrast to the hundreds of basis points of tightening delivered last year (Exhibit 1). While the year-over-year pace of inflation is still far above target in most countries, increases in prices have slowed markedly over the past six months. In the U.S., prices have been rising by a paltry 1% per year after excluding hikes in residential rents. Over the next year, we expect rent inflation to cool significantly. The impact of last year’s rapid climb in energy prices due to Russia’s invasion of Ukraine and supply-chain disruptions from the pandemic will also fade.
In addition to falling price pressures, economic activity has clearly downshifted. By our calculations, inflation-adjusted policy rates are as restrictive as they have been since before the global financial crisis (Exhibit 2). We also believe the full effect of the massive amount of tightening is yet to be felt in the economy. Traditional harbingers of economic downturns are signaling agreement with our assessment, as short-term bond yields have significantly exceeded those on longer-term bonds since the middle of last year. This inversion of the yield curve historically portends a recession some time over the ensuing two years, and we expect most of the world to fall into a mild recession by late 2023 or early 2024 – suggesting support for bond prices.
In the meantime, resilient economic activity could keep policy rates and yields higher for longer than many investors had expected even just a few months ago, as many thought the economy would be well on its way to recession by now. The economic tailwinds include remarkably strong U.S. consumer spending in the face of steeply rising borrowing costs, the positive impact on Europeans’ wallets of a warm winter and energy subsidies representing more than 5% of GDP, and China’s earlier-than-expected abandonment of the economy limiting zero-COVID policy. While disinflation has gripped most of the world in the past six months (Exhibit 3), worries about inflation becoming entrenched well above target are very real. The vast majority of the inflation slowdown is due to falling energy prices and the partial unclogging of supply chains – over which policymakers have little control. Meanwhile, the effects of the expansive fiscal and monetary response to the pandemic are taking longer to relinquish their inflationary impact. Labour markets have shown little response to aggressive central-bank policy actions over the past year. Wage inflation is near 5% in most economies, which is above levels consistent with 2% inflation over the long term. In Europe and Japan, workers are set to bank their best pay raises in decades. A re-acceleration of price pressures amid a still-strong job market would present a troubling scenario for bonds as it would indicate that more rate hikes are needed than is currently expected.
Bond investors are also grappling with questions over the sustainability of government finances in the presence of much higher yields. For more than a decade, central banks have supported government-debt markets by both cutting interest rates and purchasing vast amounts of bonds. But those measures are being forcefully reversed.
Central banks are now reducing their massive balance sheets. For Europe, this year marks the largest increase in bonds outstanding, excluding central-bank purchases, since the launch of the single currency in the early 2000s. In the U.S., burgeoning tax receipts have reduced the need to issue new debt, but worries about how future deficits will be financed are intensifying. These concerns are not restricted to the U.S. Fiscally weak members of the euro area such as Italy and Spain are facing higher levels of investor scrutiny.
In most fixed-income markets, the average coupon on existing debt is still much lower than prevailing yields (Exhibit 4). As outstanding debt matures and new bonds are issued, government coupon payments will rise significantly. This process will happen faster in some markets than others.
In the U.S. and Canada, for example, about 25% of the countries’ outstanding debt will roll over by the end of 2024 since their governments have relatively more short-term debt.
In Japan and the U.K., by contrast, that figure is barely above 10%, giving those countries a much longer period to adjust to higher financing costs. Under current policy, the share of the U.S. federal government’s annual expenditures taken up by interest payments could double over the next decade to 12% from 6% now, according to the Congressional Budget Office. While borrowing costs are also expected to climb in Canada, the relatively healthy fiscal picture means that debt-to-GDP ratios are projected to decline even in fairly negative economic scenarios. Towards the end of the summer, the U.S. Congress approaches another budget showdown over the debt ceiling. We are fairly sanguine regarding the odds of a government shutdown, but the event could bring attention to just how poor the long-run fiscal position of the U.S. government is.
Overall, we expect that a combination of strengthening economic activity, a resilient labour market and modest disinflation will prompt central bankers to continue hiking interest rates through the middle of this year, and then pause. In our view, policy rates in most markets are already high enough to dampen growth, and with price pressures easing, the risks to overtightening versus letting inflation become entrenched are more finely balanced than they were in 2022. Growth and inflation are already much slower than a year ago, and we expect that most economies will eventually slip into recession. As investors shift their attention from inflation and aggressive tightening to flagging growth, bonds should do well.
Article originally appeared in the Global Investment Outlook, published by RBC Global Asset Management (Spring, 2023).
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