Have bond markets priced in too much? – David Thornton

Bonds, more than any other security, are used as guard rails for economic health. And her professorial skills have been in high demand lately.

Among other things, they help us to predict inflation and recession. What is interesting is the recent shift in focus in the bond market from the former to the latter.

“What’s happening now is that despite high inflation and rate hikes, bond markets are actually looking at the opposite,” said Gopi Karunakaran, co-CIO at Ardea Investment Management.

“So the narrative is basically yes, inflation is high, but all these rate hikes that are priced in mean lower future inflation, lower future economic growth, possibly even future rate cuts.”

In this issue of Expert Insights, you’ll also learn why markets may have priced in too much confidence in central banks.

Edited Transcript

What risks are bond markets pricing in?

Well, there’s actually been a really big shift in what bond markets are pricing in. So if you think about it, for the most part this year has been all about inflation and rising interest rates. And we look at what the bond markets are pricing in, they’ve been very consistent with that, and that’s why bond yields have gone up so much and the bond markets have had a terrible first half, one of the worst in a long 50 years. But over the last month it has shifted dramatically in the opposite direction, which is somewhat surprising on the surface. So what is happening now is that despite high inflation and rate hikes, the bond markets are actually looking at the opposite. So basically the narrative is yes, inflation is high, but all these rate hikes that are priced in mean lower future inflation, lower future economic growth, possibly even future rate cuts.

And so you have this unusual phenomenon where, take the US as an example, where the US inflation, the CPI inflation, is printing right now, I think the last print was about 9%. But if you look at the bond market, look at inflation-linked bonds, such as B. Five-year inflation-linked bonds, the pricing basically implies an inflation expectation of something in the high twos over the next five years. So the bond market is telling you that inflation will be in the high twos for the next five years. You have an actual inflation of 9%. And the way to explain that split is basically that there’s a very, almost benign scenario that bonds are currently pricing in, that is, these rate hikes will be enough to keep inflation under control for the next few years to get. Yes. Economic growth will slow down somewhat. You may even have interest rate cuts coming up, and that’s all very conducive to risky assets. So why have stocks rallied over the past month?

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What does the inversion of the US 2-year and 10-year yield curves tell us about recession risk?

Yes. So this is pretty timely. People talk about it. So in the US, for example, if you look at two tens, that’s 30 to 40 basis points inverted, depending on the security you’re looking at. So the conventional wisdom is that yields on longer-dated bonds are typically higher than yields on shorter-dated bonds. So the curve is rising. So it’s unusual to see this inverted pattern, and basically the traditional explanation of this inverted pattern is, well, why should longer-term bond yields be lower than short-term bond yields? That’s because some expect interest rates to be lowered in the future. And that is typically associated with a slowdown in economic growth. So the traditional narrative is that growth is slowing, recession risk is rising, central banks are cutting rates to stimulate the economy, so these bond yields last longer. That’s how it usually works, and that’s the thinking behind it.

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The thing is, while the curve inverts before recessions, it also inverts without recessions. So it’s a bit of a noisy indicator. We wrote an article about it in 2019 when this happened last. I think the most important thing people should understand is the underlying assumption behind this narrative, which is that bond market prices, bond yields, and bond prices are purely a reflection of economic expectations. So basically you have all these people buying and selling bonds and they’re giving their opinions on what’s going to happen to the economy. And it’s a very pure transmission mechanism.

In reality, it’s not at all, because in bond markets prices are determined by the interaction of buyers and sellers, but those buyers and sellers are very different and they do things for very different reasons. Think of pension funds, defined benefit pension funds, they buy bonds to meet liabilities. You do not comment on the economy. The classic are central banks. They buy bonds for political reasons. So they have all these distorting powers, which means you have to be careful, I think, with just extrapolating from an inverted yield curve to a recession signal. I think what you probably want to do is take a closer look and say, yes, you have an inverted yield curve, but what are other things telling you? What does the course of short-term interest rates tell you, for example? What is the options market telling you? What do cyclicals tell you? Raw materials? Does this all align with this pattern of recession risk?

What we’re seeing right now is that there’s certainly a pattern of slowdown that’s pretty consistently priced into most things, but probably not a high probability of a recession given the risk of it being priced into most things.


Have markets priced in that central banks will do enough?

Yes. To an enormous extent, I would say, possibly even to an excessive extent. So that dramatic shift where you’ve seen bonds start moving up again, you’ve seen inflation expectations come down is a signal to us that bond markets are really way ahead with this whole rate hike pricing narrative are pure will do. And what does that mean in terms of the potential for the rally to continue or not? Well, given that there is now a very strong consensus view or expectation priced in that higher short-term interest rates will be more than enough to bring inflation back down. But that can’t really be the case. Given how much bond markets have rallied already, the onus is probably on the data, on the CPI data, to actually support the priced-in expectations.

And when you look at that, the picture isn’t entirely clear because headline inflation continues to surprise on the upside in most places. And that’s why there’s no evidence there that it’s slowing down. But perhaps if you look a little beneath the surface, you’ll see some signs that this supply-side price pressure is easing. So look at things like freight rates, energy prices, retailer inventory builds, rebates, all these things point to easing price pressures. But I think the key takeaway for me is that a lot of good news is already priced into the bond market and the onus is now on the CPI data to back that up.

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Ardea Investment Management is a specialist fixed income investment manager focused on providing clients with consistent alpha through an investment process supported by a highly intuitive risk framework. For more information please visit their website.

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