Bond markets in historic downturn as central banks fight inflation

Global bond markets have suffered their deepest decline since at least 1990 as investors brace for rapid rate hikes from central banks grappling with the highest inflation in decades.

The Bloomberg Global Aggregate Index, a broad measure of government and corporate debt, has fallen more than 11 percent from its peak in January 2021, dwarfing a 10.8 percent fall during the 2008 financial crisis and marks the sharpest pullback in the index’s history, dating back to 1990.

The sell-off has accelerated since the start of the year as central bankers signal their determination to rein in inflation, which has risen to the highest level in decades – even at the risk of stalling the economic recovery in the process. Federal Reserve Chairman Jay Powell indicated on Monday that the Federal Reserve is ready to act more aggressively if necessary to keep inflation under control after raising interest rates for the first time since 2018 last week.

Markets now expect at least seven more US rate hikes this year. The Bank of England raised interest rates for the third consecutive month this month and is expected to raise short-term borrowing costs to over 2 per cent by the end of 2022.

Even the European Central Bank outlined a quicker than expected completion of its asset purchase program at its recent meeting. His hawkish signal comes as policymakers focus on record inflation even as the eurozone is hit harder than many other global economies by the war in Ukraine.

“This is a whole different world for bond investors,” said Mike Riddell, senior portfolio manager at Allianz Global Investors. “For the last 20 years we have lived in a world where central banks look to ease monetary policy once growth begins to weaken them. Now they are determined to tighten even if it risks a recession.”

The US Treasury market – which is on course for its worst month since November 2016 – has borne the brunt of the recent selling. The US two-year note yield, which is highly sensitive to expectations for near-term interest rate movements, rose to a three-year high of 2.2 percent this week, from just 0.73 percent at the start of the year. The two-year Treasury bond is on track to post its biggest quarterly rise in yields since 1984.

Longer-term yields have also jumped, albeit at a slower pace, mainly due to rising inflation expectations, which diminish the appeal of holding securities that offer a fixed income stream long into the future. The 10-year Treasury bond yield hit 2.42 percent on Wednesday, the highest since May 2019.

Bonds in Europe have followed suit, while even government bonds in Japan – where inflation is lower and the central bank is expected to buck the global tightening trend – have posted losses this year.

Adding to the pain for investors, corporate bonds have suffered even worse losses, widening the additional yield or spread they offer compared to government bonds.

“For credit investors, the bleakest scenario is when both interest rates and credit spreads move against you,” said Tatjana Greil Castro, co-head of public markets at Muzinich & Co. “That’s exactly what we’re seeing right now.”

Bar chart of quarterly change in two-year Treasury yields (percentage points) showing the US short-term borrowing cost with the largest quarterly increase since 1984

The spread on an Ice Data Index measure for high quality European corporate bonds has widened to 1.45 percentage points from 0.98 percentage points at the end of last year. The corresponding US spread widened from 0.98 percentage points to 1.31 percentage points.

“Interest rates have risen in all jurisdictions. You can’t just say, ‘We focus on Europe or we focus on the UK’. Geographically, you have nowhere to hide,” said Greil Castro

Losses on the safest government bonds were also accompanied by a retreat on the equity markets. Although stocks have recouped most of the losses they suffered since the Russian invasion of Ukraine, major indices, including the S&P 500, remain lower so far this year.

For some investors, the moves renew doubts about the traditional role of bonds within a portfolio as a counterbalance, which tends to rally when riskier assets suffer, such as the classic “balanced” portfolio of 60 percent stocks and 40 percent bonds.

“That’s a big challenge for the 60-40 model,” said Eric Fine, portfolio manager at Van Eck. “All bond funds are seeing outflows, including Treasury funds. Investors haven’t seen this, analysts haven’t seen this, it’s a new paradigm.”

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