I’ll be back! – Mr. Bond

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” – James Carville, Political Strategist

Global bond markets are larger in size than the global equity markets and since the representation of institutional investors is greater in the global bond markets as compared to the equity markets, bond markets price action is considered more calculative and unemotional. Market pundits therefore often look at the bond markets for cues to gauge what might transpire in the equity markets. Equity markets tend to be more volatile and usually move very fast along with the developing narratives. However, equity markets typically do not stay in disagreement with bond markets for too long.

For the first quarter of the year, equity markets marched ahead in anticipation of the nearing policy pivot and support from better-than-expected earnings growth reported by corporates. Bond markets, however, continued to reel under the pressure of rising yields as expectations of policy rate cuts continued to recede on the back of higher-than-expected inflation readings and better-than-expected economic data. As the inflation data persisted, equity markets finally took notice in the month of April and the S&P 500 Index corrected by -5.5% and the S&P TSX Index corrected by about -3.2%. Better-than-expected earnings, however, from the index heavyweights put together with reporting of more benign economic data during the second half of the month brought the equity investors back to the markets.

In the United States, April was the third consecutive month where the reported headline inflation came in higher-than-expected. At +3.5% for March (reported in April), the headline inflation was ahead of the expected +3.4% and rose from +3.2% for February (reported in March). For Canada, the number was less concerning as though the headline inflation advanced to +2.9% in March (reported in April) from +2.8% in February (reported in March); it was in line with the expectations and had been falling for the previous two months. The bond markets bore the brunt of disappointing data on inflation as bond yields jumped on both sides of the border. Year-to-date, the yield curves have continued to shift upwards in the United States and Canada (See Figure 1 and 2), disappointing the investors that had bought aggressively into the “bonds are back” narrative of late 2023.

Figure 1: United States – Yield Curve (1st Jan 2024 to 8th May 2024)

Source: Bloomberg

Figure 2: Canada – Yield Curve (1st Jan 2024 to 8th May 2024)

Source: Bloomberg

The heightened bond volatility and its increased correlation with equity markets during the times of market stress has further raised questions whether Mr. Bond’s usefulness in multi asset portfolios is on a decline?  A sustainable decline in bond yields is a precondition for the asset class to reassert its importance in the portfolios which we think will be met if: a) inflation resumes is downward trajectory without signs of incremental stress on the economic growth; and/or b) economic growth decelerates, unemployment rises, and therefore the probability of policy rate cuts increases again. In the absence of these signs, the bond yields are likely to stay choppy with the ebb and flow of economic data and Central Banks’ guidance, in our view.

In the latest Federal Open Market Committee (FOMC) meeting, the committee decided to hold the interest rates at +5.50%. Bank of Canada too held the policy rate at +5.0%. The United States Federal Reserve chair, Jerome Powell, noticed that the recent data suggests the progress on inflation has stalled, however, cited several reasons why he remains optimistic that inflation will be back under control. Labor market is coming back to a better balance and expectations that the contribution of shelter inflation component of inflation calculations will eventually decline as current rents paid begin to reflect in the CPI calculations are the reasons to stay optimistic that “sticky inflation” narrative might not stick for long. The FOMC committee also decided to taper off the quantitative tightening by deciding to reduce the runoff to $25 billion in Treasury bonds each month from the current $60 billion per month from 1 June 2024. This did provide support to the bond markets during early May so far, however, in the current environment, we think continued progress on inflation and/or deterioration in the economic growth and hence a shift in policy rates are the conditions where the narrative of “bonds are back” can hold sustainably.