Bond markets in turmoil

There are relatively few investors who have ever experienced such price movements on the purportedly “safe” bond markets.

• Around ten years of yield declines have been “erased” in just a few months.

• Numerous factors are fuelling inflation and putting the central banks in a tight spot.

• Bonds are once again offering decent yields and earnings potential for the first time in over ten years.

• Price fluctuations: Have they come (or rather returned) to stay?

• Outlook: Permanent reversal and a more profitable bond environment again?

Naturally, this article cannot undo the price declines. But it can provide explanations for these developments and give insight into what may come after these extraordinary price movements.

Historic interest rate trend in the rear-view mirror

It took about ten years for the yields of ten-year Austrian government bonds to fall from around 2.2% p.a. to their absolute low of approximately minus 0.6% p.a. When the European Central Bank (ECB) launched its zero and negative interest rate policy, virtually no one expected it to last an entire decade. At times, global bonds with an equivalent value of over EUR 15 trillion were trading with negative nominal yields – and they were still purchased!

The great yield jump of 2021/2022

It only took about half a year for this long yield decline to be completely wiped out. All of us have now been brutally and abruptly ripped out of this long-lasting phase of ultra-low interest rates and very moderate inflation. Perhaps the era of declining inflation rates was drawing to a close anyway, or maybe it could have gone on for another few years. However, a number of developments with inflationary impacts burst onto the scene quite suddenly: the partial reversal of globalisation (including outsourcing) due to increased geopolitical tensions (e.g. China-USA), tremendous disruptions due to the COVID pandemic and the imposed lockdowns, years of underinvestment in the production of oil, gas, and industrial metals, and the war in Ukraine along with the unprecedented sanctions imposed against Russia by Western nations. The central banks were very late to react to all of these developments. Now they are trying to get things back under control. In this context, it must be noted that a portion of the current inflationary pressure was neither created by monetary policy nor can it be eliminated by monetary policy.

About-turn on the bond markets

For the bond markets, this has led to an unexpectedly rapid, nearly seamless about-turn from a long period of ultra-loose central bank policy and low inflation to a new (old) regime of higher inflation and monetary policy that is no longer supportive per se. Accordingly, the market movements in recent months have been drastic and fast to an extent that has ultimately caught everyone off guard.

Why have the prices of “safe” bonds fallen so dramatically?

Bond prices rise when yields fall. Conversely, prices fall when yields rise. It is easy to explain why this is the case.

Example: Let’s say that a bond with a remaining term of ten years is listed at a price of 100 on the market with a coupon of 1% and thus offers a yield of 1%. If the yield level on the markets for comparable bonds (term, rating) rises to 2%, this bond naturally has to offer this level as well; otherwise, investors would sell it and buy the bonds that offer a yield of 2% instead. Because the coupon is fixed, the adjustment has to take place via the bond price. Roughly estimated, the price for this bond has to drop to around 90. And that’s a price decline of about 10%! Under normal circumstances, such adjustments occur at a rather leisurely pace on the bond markets and are spread out over several quarters or even years. At the moment, however, they are happening within just a few weeks and thus resulting in a very high number of significant price swings in a short time. This price adjustment effect in response to yield changes is more pronounced the longer the remaining term of a bond is, so yield changes have a much bigger impact on long-term bonds and hardly any impact to none at all on short-dated issues.

Naturally – and this is important – a portion of the price declines is only temporary in nature, provided that the bond issuer remains solvent. Because even issues that are currently listed below the nominal price are redeemed at 100% at the end of the term.

One door closes and another one opens

The positive flip side of the recent massive rise in yields and the associated price declines is the fact that bonds in the Eurozone are once again offering decent absolute earnings for the first time in a decade. Therefore, not only private investors but also institutional investors (such as insurance companies and pension funds) are breathing a major sigh of relief, also when it comes to reinvesting maturing bonds. This means that the risk-return profile is improving considerably for bond funds and mixed funds. As a result, some bond funds or bond portfolios in mixed funds now once again have a yield level of around 3% or higher (as of June 2022), which represents a solid basis for future earnings opportunities.

Price fluctuations “normal” on the bond markets again?

It appears that not only the negative interest rate phase in the Eurozone is a thing of the past for the time being, but also the associated period of extremely low volatility on the bond markets. Although the current price movements are the most pronounced in recent decades, price fluctuations are not that out of the ordinary, and are in fact roughly in line with the conditions that were entirely commonplace on the bond markets prior to 2012. The massive, sustained market interventions by the central banks and the environment of persistently low inflation rate pushed price volatility for bonds far below the normal historical levels over the past decade. Due to the habituation effect of artificially low volatility over a long period of time, the current movements now appear all the more severe.

Future of the bond markets: How might things progress?

Put simply, the bond markets in the Eurozone and the USA are currently attempting to newly price in conditions where they will be left to their own devices, with no massive, direct and sustained market interventions by the central banks.

Right now, the bond markets are primarily caught between inflation and recession risks on the one hand and significantly less support – even bordering on headwinds – from the monetary policy side on the other. The US central bank (the Federal Reserve, or Fed) and the ECB have certainly made a better and more trustworthy impression in the past than currently, where their actions seem to be characterised by a certain degree of hecticness and rather erratic decisions, along with similarly imperfect communication. Nevertheless, the central banks have convinced the markets for the time being that they are serious about fighting inflation and want to raise interest rates and reduce liquidity, even if it means ushering in an economic downturn. Whether and for how long the central banks will maintain this stance is another matter and is also already being widely discussed on the markets.

Inflationary pressure versus recessionary risks

For the time being, however, the rate hikes are likely to continue – at least for as long as there is no sustained relief with regard to the inflationary pressure. Makes sense so far, right?

The crucial question that no one can reliably answer right now – presumably not even the central banks themselves – is what will happen if economic conditions weaken much more significantly and quickly than inflation? Such a scenario is certainly one of the risks for the bond markets at the moment, particularly in the Eurozone. This would lead to additional uncertainties and put the central banks in a much more difficult position. Then they would essentially have to combat a recession and inflation at the same time. This is a practically impossible balancing act that would force the central banks to choose one of these two objectives.

However, such a scenario is only one of several possible developments, and much more favourable alternatives are also conceivable. At this point in time at least, it seems doubtful that the ECB will raise interest rates as currently planned if the risks of a recession materialise and increase significantly. As a result, the markets have started pricing in somewhat less aggressive rate hikes in recent days, particularly in the Eurozone. However, they currently reflect very rapid and pronounced rate hikes in both the USA and Europe for the coming months.

Conclusion: Permanent regime change on the bond markets?

The volatility on the bond markets will presumably continue for some time while a new state of equilibrium sets in for the drastically different environment. It is currently extremely difficult to impossible to make a reasonably precise estimation for yields and price levels for the next one to two years. There are simply too many uncertainties and contradictory factors. In the best-case scenario for bond investors, a situation will emerge in the coming years in which inflation declines significantly again and positive real yields (i.e. nominal yields minus inflation) can also be generated again and in which the central banks are much more restrained. At any rate, this would be a welcome departure from more than a decade of zero and negative interest rate policy. Naturally, only time will tell whether this comes to fruition.