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Active Thinking: The great rates market sell-off: What now?

Many market commentators and money managers have been recommending going long interest rate duration for months now – but markets have shown no sign of turning in their favour yet. Indeed, we may still not be done, argues Ralph Gasser, Head of Fixed Income Investment Specialists.

30 October 2023

Being long interest rate duration risk used to be a profitable business. Not anymore. In fact, the market yields correction that commenced in earnest at the start of 2022 has since turned into the worst drawdown in terms of nominal total returns since the late 18th century.

Looking at the benchmark 10-year US Treasury bond, for instance, 2022 was its annus horribilis, with the annual total return – the combination of yield carry and market price change – coming in at an unprecedented -16.3%. And with rates markets continuing to sell off this year, three-year rolling total returns now print at -24.5% (as of 25-Oct-23), a drawdown more than twice as bad as the worst corresponding period in history. This picture does not look too dissimilar elsewhere, namely across most of the advanced economies.

The worst nominal return drawdown period for interest rate risk since the late 18th century

 
Source: Bloomberg, Academic study “Stocks for the Long Run? Sometimes Yes. Sometimes No” by Edward F. McQuarrie, Professor Emeritus, Santa Clara University, July 2021, in response to Jeremy Siegel’s *Stocks for the Long Run* thesis. GAM. Note: Data as of 25-Oct-23.

Looking at the drivers behind this selloff, we can break up nominal yields into their underlying subcomponents; breakeven rates, i.e. market-implied inflation expectations derived from same duration inflation-linked bonds, and residual real rates.

As illustrated below, fast-rising inflation expectations reflected via breakeven rates were the dominant force behind nominal rates in 2020. But this was largely offset by still-declining real rates. This changed dramatically at the start of 2022, however, and while 10-year breakeven rates settled within a 2.25% to 2.5% range, real rates surged by more than 3.5% since the start of 2022 and still show no signs turning.

The look behind the scenes – Breaking up nominal yields into their subcomponents

 
Source: Bloomberg, GAM. Note: Data as of 25-Oct-23.

But why this blowout in real rates? And what should we expect from here?

In theory, and very broadly speaking, the real rate should be the rate at which inflation is kept at target and the economy operates at full employment – neither expansionary nor contractionary. In practice, and largely reflecting this, real interest rates across maturities and most advanced economies have been in steady decline since the mid-1980s, which was supercharged by the various extraordinary monetary policy measures introduced by central banks ever since the global financial crisis.

But times have changed. Most crucially, central banks’ monetary policy has tightened aggressively since 2022 in response to uncomfortably high inflation, both by raising headline rates and by starting to run down the massive bond holdings accumulated over previous quantitative easing (QE) programmes.

The reversal of real interest rates – Central banks’ aggressive monetary policy tightening

 
Source: Bloomberg, GAM. Note: Data as of 25-Oct-23.

Given the extreme correction we have seen in real interest rates, and with it, nominal rates, are we back to fair value today, with calmer waters ahead?

If we take it that the drivers behind real interest rates are broadly similar to those driving economic activity, the answer at first sight would most probably be “yes”. Real rates are at last back to real GDP growth rates, as they used to be for most of times before the extraordinary monetary policy measures introduced by central banks. This “yes”, however, implies that the current consensus market forecasts on real and nominal economic growth are correct and that valuations are purely driven by fundamentals – which we all know is most of the time not the case.

The realignment of real interest rates with fundamentals

 
Source: Bloomberg, GAM. Note: Data as of 25-Oct-23. Note: US real and nominal GDP forecasts for next four quarters based on latest composites of economists polled by Bloomberg.

Indeed, in my view, there are still plenty of headwinds ahead for both real and nominal yields. To name just a few, there is plenty of surprise potential attached to current economic forecasts, both to the up- and downside in a world of fragile geopolitics. Also, central banks in the West may be largely done with hiking rates but running down the massive bond holdings accumulated over previous QE programmes is not. This removes a central marginal buyer of core market bonds.

In addition, the US government is set to run an annual budget deficit of around -6% of GDP each year for the next three years, almost double the typical structural run rate of -3% to -3.5%. On top, heavy refinancing of existing government and corporate bonds will hit bond markets in 2024, all searching for a bid at the same time. And lastly, in a higher-for-longer short-term rates environment, the record amounts of cash today held in short-term products will have to be lured out the curve to meet these huge financing demands, which will require positive not negative term premiums, and an end to inverted interest rate structures.

All these factors do not support a decline in real rates anytime soon – rather the opposite. If we add that core inflation remains sticky and deflationary base effects of food and energy prices are already waining fast, breakevens, too, may be subject to upside surprises from here.

So while being long interest rate duration risk may at first sight appear to be a profitable business again, a more sober perspective, particularly on old-fashioned supply and demand dynamics, suggests otherwise. At least today’s yield carry returns do provide for some comfort.

Important disclosures and information
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Past results are not necessarily indicative of future results. Investors could lose some or all of their investments.

The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.

Ralph Gasser

Investment Specialist
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