Thursday, November 30, 2023

bond: Global Bond Rout: The return of bond bears?

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It is hard to miss when something hits a multi-year high. But, if it is a multi-decadal high, it is time to sit-up and take notice. The bond markets are currently experiencing a seismic shift, one that has caught the attention of both seasoned and novice investors alike. For many who have watched the history of markets, it is reminiscent of the days when the bond bears held sway back in the 1980s. What is happening in the global bond markets isn’t just a blip on the radar; it is a signal that can’t be ignored for long.

Beginning September this year, global yields have galloped to lofty levels not seen for many years and decades. Since bond prices correlate inversely to their yield, there has been a splash of red across bond markets with bond prices slumping to new lows. US ten-year treasury yield is near 5%, the level it had not touched since the onset of the global financial crisis in 2007. Mortgage rates saw a ruinous rub-off effect from this with the rates surging to near 23-year high of 8% in the US. This is not a phenomenon that is limited only to the US. The bond rout has spread much beyond the US shores signifying a major shift in the overall market environment. In Germany, the yields have hit their highest level not seen since the 2011-euro crisis. And, in Japan, where the central bank is still struggling with falling currency on zero interest rate regime, the market yields have leapt to 2013 highs. Now, with global bond markets in a serious slump, it looks like the bond bears are back with a bang.

What has caused this depressive outlook for bond markets and what has changed since the start of September?
To understand this, let us first look at the signals that are coming from the US Fed Chair on the interest rate outlook. On that, the picture out there can’t be patchier. Few months back, it was less formidable to forecast rate cuts beginning next year. Now, that comfort has long gone.

With the Fed signaling a “higher-for-longer” scenario, things have turned topsy-turvy for global rates and currency markets. There is a complete flux out there. The markets’ concern is less about the elevated levels, but more about how long it is going to stay at higher levels. The proponents of early rate cuts are dwindling by the day with almost everyone resigning to the fact that the elevated rates are here to stay for a much longer period.

The financial markets find themselves in a state of shock. The debates are no longer on when the rates will normalize but have shifted to the realization that elevated rates are likely to endure for a much more extended period. This departure from earlier expectations has triggered a wave of adjustments across the global yield curve.

Does this global rout signify a regime change in the investment environment? Some veteran investors like Howard Marks believe so. In his latest memo, titled “Further Thoughts on Sea Change”, he alludes to this by stating that this high yield environment isn’t just cyclical fluctuations; rather, taken together, they represent a sweeping alteration of the investment setting, calling for significant capital reallocation. He further adds, it has been years since prospective returns on credit were competitive with those on equities. Now, it is the case again as per his prognosis. Basically, he is hinting at higher rates for protracted periods and batting for higher allocation to debt.

Now, let us turn our attention to the implications for India in terms of interest rates and currency management in this supposedly new regime if it were to manifest.

Here, one thing is fairly clear that if the global interest rates are going to stay high, RBI will have limited headroom to cut rates even if India’s inflation moderates to a manageable range which it is likely to. This limitation stems from the intricate relationship between currency values and interest rates.

To maintain the stability of Indian rupee, RBI could be compelled to navigate the global high interest rate environment, with a limited leeway to cut rates even as inflation trends lower. This in essence, implies that India might not be able to escape the “higher-for-longer” phenomenon. In other words, investors in India need to factor in elevated yields for an extended period. Needless to say, this will provide an opportunity for credit investors in terms of competitive returns.

Having said that, in India’s case, given the stage of growth cycle in which we are, alpha creation in equities will not be a challenge given the large size of bottom-up opportunities.

Indeed, we find ourselves in a captivating and transformative period. The question of whether the bond bears are here for the long haul or will recede swiftly remains uncertain. The evolving financial landscape presents both challenges and opportunities. Only time will tell whether this global bond rout is just a blip or signifies something more serious. Interesting times to watch out for!

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