Have bond markets priced in too much?

Bonds, more than any other security, are used as bellwethers of economic health. And their professorial prowess has been in high demand lately. 

Among other things, they help us predict inflation and recession. What's interesting is the recent shift in focus within the bond market from the former to the latter. 

"What's happening now is bond markets are actually looking through high inflation and rate hikes to the opposite," says Gopi Karunakaran, co-CIO at Ardea Investment Management. 

"So the narrative basically is that yes, inflation's high, but all these rate hikes that are priced in mean lower inflation in the future, lower economic growth in the future, possibly even rate cuts in the future."

In this edition of Expert Insights, you'll also hear why markets may have priced in too much confidence in central banks. 

Edited transcript

What risks are bond markets pricing in?

Well, there's been actually a really big shift in terms of what bond markets are pricing in. So if you think about, for most of this year, it's been all about inflation and rising rates. And we look at what bond markets are pricing in, they've been very consistent with that, and that's why bond yields have been going up so much and bond markets have had a terrible first six months of the year, one of the worst in 50 years. But over the past month, it's dramatically shifted the opposite way, which is somewhat surprising on the surface. So what's happening now is bond markets are actually looking through high inflation and rate hikes to the opposite. So the narrative basically is that yes, inflation's high, but all these rate hikes that are priced in mean lower inflation in the future, lower economic growth in the future, possibly even rate cuts in the future.

And so you have this unusual phenomenon where, take the US as an example where US inflation, CPI inflation is currently printing, I think the last print was around 9%. But when you look to the bond market, you look at inflation linked bonds, like five year inflation linked bonds, the pricing basically implies an expectation for inflation over the next five years of something in the high twos. So you've got the bond market telling you for the next five years, inflation's going to be in the high twos. You've got actual inflation running at 9%. And the way to explain that disconnect is basically that, well, there's a very, almost benign scenario being priced in by bonds right now, which is, these rate hikes will be enough to get inflation under control in the next couple of years. Yes. Economic growth will slow a bit. Maybe you might even have rate cuts coming through, and that's all very supportive for risk assets, hence why equities have been rallying over the last month?

What does the inversion of the US 2YR and 10YR yield curve tell us about recession risk?

Yeah. So this is something that's pretty topical. People talk about it. So if you look in the US, for example, two tens, it's inverted 30 to 40 basis points, depending what securities you look at. So the conventional thinking there is that normally longer dated bond yields are higher than shorter dated bond yields. So the curve is upward sloping. So it's unusual to see this inverted pattern, and the traditional explanation of that inverted pattern is basically saying, well, why would longer dated bond yields be lower than short dated bond yields? It's because there's some expectation that interest rates are going to get cut in the future. And typically that's associated with economic growth slowing. So the traditional narrative is growth slows, recession risk rises, central banks cut rates to stimulate the economy, therefore longer those bond yields go. So that's how it usually works, and that's the thinking behind it.

The thing is that while the curve does invert before recessions, it also inverts without recessions. So it's somewhat of a noisy indicator. We wrote an article about this in 2019, the last time this happened. I think the key thing that people should understand is the underlying assumption behind that narrative, it says that market pricing of bonds, bond yields, bond prices, is a pure reflection of economic expectations. So basically you've got all these people buying and selling bonds and they're expressing their view on what's going to happen to the economy. And it's a very pure transmission mechanism.

The reality is it's not at all, because in bond markets, prices are determined by buyers and sellers interacting, but those buyers and sellers are very diverse and they're doing things for all kinds of different reasons. Think about pension funds, defined benefit pension funds, they are buying bonds to match liabilities. They're not expressing a view on the economy. The classic is central banks. They're buying bonds for policy reasons. So they got all these distortionary forces, which means that you've got to be careful, I think, just extrapolating from an inverted yield curve to a recession signal. I think what you'll probably want to do is take a more granular approach to it and say, yes, you've got an inverted yield curve, but what are other things telling you? For example, what is the path of short term rates telling you? What is the option market telling you? What are cyclicals telling you? Commodities? Is that all consistent with that pattern of recession risk?

What we see at the moment is there's certainly a pattern of slowdown that's being priced in pretty consistently across most things, but probably not high probability of recession, risk being priced into most things.

Have markets priced in that central banks will do enough?

Yeah. To a huge extent, I'd say, possibly even to too much of an extent. So that dramatic shift where you've seen bonds start to rally again, you've seen inflation expectations coming down, to us, that's a signal that bond markets have really run quite far ahead with this whole narrative that the rate hikes that are priced in will be enough. And what does that mean in terms of the potential for the rally to continue or not continue? Well, if you think about there's one very strong consensus view or expectation now priced in, i.e, higher short term rates will be more than enough to bring inflation back down again. But that may not actually be the case. So given how much bond markets have rallied already, the burden of proof is probably now on the data, on the CPI data, to actually back up what expectations are being priced in.

And when you look at that, the picture's not totally clear because headline inflation in most places continues to surprise to the upside. And so there's no evidence there if it's slowing. But maybe when you look under the surface a little bit, you do see some indications that those supply side price pressures are moderating. So you look at things like freight rates, energy prices, inventory build amongst retailers, discounting, all those kinds of things are pointing to moderating pricing pressures. But I think the key takeaway for me is a lot of good news is already priced into the bond market, and the burden of proof now is on the CPI data to back that up.

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Ardea Investment Management is a specialist fixed income investment manager with a focus on delivering consistent alpha to clients through an investment process supported by a highly intuitive risk system. For further information, please visit their website. 

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