Jonathan Gregory
Head of UK Fixed Income

January 2023 – A thicker cushion against another bad landing

A very long time ago my high-school’s recently appointed (and overly-ambitious) head of athletics felt compelled to introduce ‘modern’ and ‘exciting’ new sports.

Despite, in a sporting sense, being one of the most deprived schools in the neighbourhood – one which struggled to even equip goalposts with nets – the agenda was bold. Track and field sessions now herded the fearless and the nervous (you may guess my camp) in some impressive new directions. Most fearsome of all, for me, was the pole vault. While our coach majored on the need for speed, agility, strength, coordination and technical skill, all I could focus on was the thickness of the safety mat – which was never enough. While I do not remember a single successful vault, I do remember every face-plant, belly-flop and backward-tumble.

The need for adequate safety has again been on my mind recently. Few investors will mourn the end of 2022, the year when global broad-market bond indices lost about 12%, the worst return in living memory. It also marks the first consecutive years of losses in global bonds that I can remember in a career spanning over three decades. Might bond investors get some relief in 2023? We cannot know for sure, but I am optimistic. As I face down the runway I am at least comforted to see the thickest safety mat in place for some time.

Painful transitions

Before I get to that, it is true central banks remain firmly in policy bleak-midwinter. Two events were noteworthy in December. Late in the month the Bank of Japan (BoJ) surprised almost everyone with an important shift in policymaking. Since 2016 the BoJ has manipulated bond markets to keep the yield on 10-year bonds at close to 0% via a policy known as “yield curve control” (YCC). In effect, this implies an almost unlimited form of quantitative easing (QE), or bond purchases, by the central bank designed to keep yields low and drive inflation back up to target.

Elsewhere, inflation running well above target meant most other central banks had already reversed course on ultra-loose monetary policies such as QE. So, by late 2022, the BoJ was a serious outlier. Sticking rigidly to a negative policy rate (remember them?) and YCC, the bank insisted that Japanese inflation was a temporary problem and mostly supply-side driven. But then suddenly in December the BoJ lifted the cap on 10-year yields to a higher range than it previously set. This may not seem like a big deal as the BoJ had not abandoned negative rates, YCC or QE – just taken a step back from the extent of its commitment to loose policy.

But perhaps that is the point – almost every other developed-market central bank around the world only changed tack from the ultra-loose policies of the COVID-world to the much more hawkish policies of today after a lengthy period of denial about the scale of the policy response require to fight higher inflation.

Those policy transitions almost always had bad outcomes for bondholders. When the Reserve Bank of Australia abandoned its own version of YCC in 2021, targeted yields rose 1% in just a few weeks and now stand about 3% higher. The Fed started to slow asset purchases (remember that?) in November 2021; now a year later and the Fed is selling assets and policy rates travel to the moon. Slowing QE was the start of a major policy reversal – not the end.

For global investors, there is therefore still good reason to be short Japan, and we remain so in our strategies. Yields have certainly popped higher since the BoJ tweaked the policy, but given we are likely at the early stages of the policy transition, short positions appear to offer good risk reward (Japan is still easily the lowest yielding bond market in the G7). In fact, even with this change there remains something inconsistent about policy making in Japan; on the one hand YCC, and implied unlimited QE, generally act to weaken a currency – and this was certainly the case with the yen, which lost about 20% in value year-to-date versus the US Dollar by early December. But that same currency weakness was also a major driver of domestic inflation, forcing the Japanese authorities to intervene in currency markets, buying the yen to help support its value since mid-November.

Japan spent at least USD62bn to support the yen since September, yet at the same time spent US$128bn buying 10-year bonds in December as part of YCC to try and cap the yield at the new higher level.1

To some extent these policies act in opposite directions. In our experience, inconsistent policies usually break-down pretty quickly and often more quickly than people imagine.
The second blast of chill tidings for investors blew from the Fed and the ECB. At face value there wasn’t much to be worried about. Both central banks delivered December rate hikes fully anticipated by markets – 0.5% in each case – and both lowered the magnitude of the increases from prior meetings.

But, while some may have cheered the lower scale of hikes as sign of some policy thaw to come, the devil was in the detail. Both released economic projections for coming years and one point was striking; their outlooks for 2023 showed higher expected inflation and lower expected growth relative to their September projections – so in the space of just three months the mood music has become rather more gloomy.

By forecasting higher expected inflation, perhaps it was not surprising that both central banks saw little scope for lower policy rates from here (the Fed even revising upwards its expectations for the end of 2023). Chart 1 and 2 highlight the changes across both banks, but the theme is one we have talked about for a while now; investors must fully acclimatise to a world of lower growth and higher inflation than they have experienced for many years.

Chart 1: ECB Macroeconomic projections

European economic and inflation projections for 2022 through to 2024.

Bar graph showing the ECB European economic and inflation projections for 2022 through to 2024.

Chart 2: Federal Reserve macroeconomic projections

US economic and inflation projections for 2022 through to 2024.

Bar graph showing Federal Reserve economic and inflation projections for 2022 through to 2024

Since mid-November bond yields in the US and Eurozone staged a mini-rally (prices rose as yields fell) as optimism grew that peak inflation had passed. But, as Chart 3 shows, yields rose again in December as the implications of BoJ, Fed and ECB comments and policy action were digested.

Chart 3: 10-year US Treasuries and German Bund Yields, Calendar Year 2022

Fluctuations of 10-year US Treasury bond yields and 10-year German bond yields in 2022

A line chart showing the fluctuations of 10-year US Treasury bond yield and 10-year German bond yield through 2022. 

So could we see a third straight year of losses for bondholders? Well, potentially – but we should not lose sight of the positives.

One silver lining in the relentless move higher in yields in 2022 is that it sets a higher bar against losses in 2023. In general, the higher the level of yields, the larger the scale of increases that are required to generate a negative total return over the next twelve months. Simply put, higher yields (income) mean a bigger cushion against falling prices.

We can think about it as a ‘breakeven’ level for bond yields – if we buy bonds today at the prevailing yields, how much further must bond yields rise (with the associated fall in prices) to cancel-out that income over 12 months? The answer will be different across different markets but in Table 1 I have summarised a few of the most common bond indices followed by investors today.2

Index

Index

Break-even at end Dec 2021 (bps)

Break-even at end Dec 2021 (bps)

Break-even at end Dec 2022 (bps)

Break-even at end Dec 2022 (bps)

Extra cushion to absorb rising yields (bps)

Extra cushion to absorb rising yields (bps)

Index

Bloomberg Global Aggregate Index

Break-even at end Dec 2021 (bps)

17

Break-even at end Dec 2022 (bps)

56

Extra cushion to absorb rising yields (bps)

38

Index

Bloomberg Global Aggregate 1-3 Year Index

Break-even at end Dec 2021 (bps)

38

Break-even at end Dec 2022 (bps)

192

Extra cushion to absorb rising yields (bps)

155

Index

Bloomberg Global High Yield Index

Break-even at end Dec 2021 (bps)

114

Break-even at end Dec 2022 (bps)

230

Extra cushion to absorb rising yields (bps)

116

Index

ICE BofA Euro High Yield Constrained Index

Break-even at end Dec 2021 (bps)

134

Break-even at end Dec 2022 (bps)

276

Extra cushion to absorb rising yields (bps)

142

Index

Bloomberg Global Aggregate Corporates Index

Break-even at end Dec 2021 (bps)

25

Break-even at end Dec 2022 (bps)

85

Extra cushion to absorb rising yields (bps)

59

Index

ICE BofA 1-3 Year Eurodollar Index

Break-even at end Dec 2021 (bps)

63

Break-even at end Dec 2022 (bps)

282

Extra cushion to absorb rising yields (bps)

219

Index

JPM EMBI Global Diversified Index*

Break-even at end Dec 2021 (bps)

66

Break-even at end Dec 2022 (bps)

125

Extra cushion to absorb rising yields (bps)

59

Source: UBS, JP Morgan, Bloomberg Finance L.P., as of end December 2022
Past performance is not indicative of future results.

*JPM EMBI Global Diversified Index figures as of end November 2022.

Note this table is for illustrative purposes only and is in no way indicative of future returns or yield levels.

On 1st January 2022 the Bloomberg Barclays Global Aggregate Index yielded just over 1%. With a duration of nearly 8 years, the ‘breakeven’ (or cushion against losses) was just 0.17% (almost nothing). Fast forward to 1st January 2023 and that same index now yields 3.8% and has a breakeven of 0.56%; so nearly four times the annual income and breakeven. The shorter the duration and/or the higher the starting yield, then the bigger the cushion; so 1-3 year global bonds have a breakeven of nearly 2% and Euro high yield nearly 2.8%.

These somewhat larger cushions against losses today relative to a year ago stem from the major repricing of bond markets in 2022. And markets are forward looking, so already price a degree of further tightening to come from central banks; these factors were largely absent in bond market pricing a year ago.

Better valuations aside, an unprecedented third straight year of losses in 2023 is, of course, still possible. But the conclusions from Table 1 were one factor in our becoming more constructive on bonds towards the end of last year. They helped shape our thinking about the best opportunities I outlined last month; US broad market, US inflation protected securities, global bonds and Euro high yield.

And I can tell you – the thickness of the cushion seriously affects your enjoyment.

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