Bonds should (theoretically, at least) perform well in an interest rate-cutting cycle, but Royal London Asset Management (RLAM) is bracing itself for a “bloodbath” next year.
Rates aren’t being cut in a vacuum; a host of other factors, from geopolitical tension to rising levels of government debt, to a resurgence of inflation could drag on fixed-income performance next year. So much so that Trevor Greetham, head of multi-asset, said he is “nervous about another bond market bloodbath”.
Investors have gotten swept up by enthusiasm over central banks’ decisions to cut rates and the market has priced in rate cuts that Greetham fears won’t happen.
The spectre of inflation still simmers beneath the surface and if it starts to rise again, the fixed-income market could see a major reversal in fortunes, he warned. This tension is most clearly felt in the US, which faces a combination of high government debt and spending commitments that could cause a surge in inflation.
Senior economist Melanie Baker said: “It feels like inflation has been put on the back burner because the central banks are already cutting rates, but this is not the case.”
Rising prices in the world’s leading economy could trigger another rate-hiking cycle that would further reduce the price of bonds. This would encourage a major sell-off: a “bloodbath” for the fixed-income market.
However, the RLAM team acknowledged that it is difficult to say with certainty whether this scenario will play out.
RLAM predicts that service sector inflation may not drop as expected and headline inflation could start to pick up in the coming months, reducing the chance of further rate cuts. “Inflation could come back before you know it,” Greetham added.
Historically, periods of rate cuts have often been followed by periods of intense rate hikes, said Greetham so it is crucial not to underestimate the volatility of the fixed-income market. For example, between September and December 1998, the Federal Reserve embarked on three months of rate cuts, but only six months later interest rates rose again.
Financial market behaviour during Federal Reserve easing cycles
2024103_RLAM_2
Source: RLAM. Changes between first and last Fed rate cuts. Annualised total returns in US dollars using S&P Composite index for stocks, 10-year US Treasuries for bonds and the GSCI index for commodities.
Consequently, while we are currently at the start of central banks’ cost-cutting cycles in the US, UK and Europe, it is difficult to determine how long they will last.
If inflation data starts to turn around and interest rates start to rise, fixed-income investment will become far less attractive.
Greetham said: “What we see now is the beginning of a Fed easing cycle. So, the question is, are they easing because things are falling apart? We don’t think so. In which case, there could be upside growth surprises coming and that could bring inflation back.”
Next year will mark the fifth anniversary of the "bonanza" of five-year US government bonds issued to pay for pandemic-era economic stimulus, meaning that the US will face a massive re-financing need.
Additionally, Uncle Sam faces a budget deficit of almost 7%, which the next president must confront. Presidential candidates Donald Trump and Kamala Harris appear to be ignoring the deficit and have promised $5trn and $2trn in spending, respectively.
While the US "gets away with quite a lot as the world's reserve currency", Greetham remains concerned that ignoring the deficit while making large spending commitments could reignite inflation. “The main message from geopolitics is that inflation hasn’t gone away,” he added.
If inflation in leading economies such as the US does pick up next year, history suggests that central banks will react with an aggressive rate hike campaign, Greetham said.
This flies in the face of current consensus; rate cuts of around 180 basis points are priced in for this year alone.
The dissonance between market expectations and underlying tensions could cause a bloodbath, Greetham said.
This has led RLAM’s multi-asset team to take a cautious approach and to put in place several hedges against inflation. Their portfolios remain overweight commodities, gold and the UK: areas with value tilts that hold up well during rising inflation. Greetham particularly favours UK property, is recovering due to stabilising rents and usually fares well during periods of inflation.
Nevertheless, for all the talk of a bond market crisis next year, Greetham and Baker admitted that current market optimism is understandable. Recent inflation data has been very reassuring, allowing central banks to cut rates at a steady pace.
Moreover, fixed income recorded its highest monthly inflows year-to-date of £1.8bn in August, according to the Investment Association, indicating that the asset class still appears to be attractive to many investors.