Co‑Head of Strategic Fixed Income Jenna Barnard outlines how the team’s cyclical process for managing bond exposures is signaling a collapse in U.S. government bond yields around springtime.
- We monitor, and project out, the pace of accelerations or decelerations in economic data – rather than the actual "level" – in order to judge the directionality and magnitude of bond yield moves.
- Come spring 2022, this approach is anticipating a collapse in the year-on-year rate of change of the economic data in the U.S., reflecting the exceptional strength of its economy in the prior year.
- The long overdue shift to a hiking cycle from developed world central banks may mark the end, rather than the beginning, of the sell-off in government bonds, which dates back to August 2020.
The beginning of 2022 has set up our long anticipated clash between hawkish central banks reacting to peak inflation numbers and our own macro investment process forecasting lower bond yields over the course of 2022.
In this short note we will discuss why, since August 2021, we have been flagging early 2022 as the potential cyclical high in bond yields, when this seems so at odds with the narrative of higher interest rates and government bond yields that you will read about in the media. Indeed, we think the long overdue shift to a hiking cycle from developed world central banks is providing an opportunity to add duration (interest rate sensitivity)/government bond exposure and may mark the end, rather than the beginning, of the sell-off in government bonds, which dates back to August 2020.
We have been patiently waiting for this moment for the last five months. It is likely to provide a classic case study of the truism that it is the bond market (which correctly anticipates turning points in the economic cycle) that drives the U.S. Federal Reserve (Fed)’s decisions – and not the other way around.
First a Recap: Our Cyclical Process for Managing Government Bond Exposure
We monitor and project out the second derivative* of economic data (i.e., the pace of acceleration or deceleration in the data, rather than the actual "level") in order to judge the directionality and magnitude of 10‑year and longer‑dated bond yield moves.
We have published a more detailed discussion of this approach in the past. In a post-COVID crash world, there are enormous base effects driving sharp inflections in the year-on-year rate of change of economic data, which have caused sharp narrative shifts in markets, from reflation to stagflation and, soon, slowdown.
Indeed, come spring 2022, our approach is anticipating a collapse in the year-on-year rate of change of economic data in the U.S., reflecting the exceptional strength of the economy in the prior year – based on the reopening of the economy in spring 2021, stimulus measures to combat the consequences of the pandemic and the peak in the reflation narrative.
Using our rate of change model, which our quantitative analyst Dillan Shah maintains and develops, the forecast of the collapse in bond yields comes with one of the highest degrees of certainty in many years, driven by these extreme base effects. Inflation is the most obvious example of this inflection point but it applies equally to the growth data.
Our Rate of Change Model’s Forecast Is Complemented by Mainstream Analysis
While monitoring these kind of inflection points in economic momentum can provide us with an edge against linear economic narratives based on extrapolating recent trends, we look for confirmation of potential turning points by complementing this approach with macro processes focused on forecasting the demand side of the global economy.
Note, we are driven by process, not narratives. These approaches predominantly focus on the global goods cycle (as services cycles are so muted) relative to historical trends. Some of the most common data that investors would examine include Purchasing Managers’ Indices (PMIs) and the Institute for Supply Management (ISM) manufacturing reports’ inflection points, utilizing lead indicators like new orders versus inventories, Organisation for Economic Co-Operation and Development (OECD) lead indicators and monetary (i.e., interest rates and exchange rate) conditions.
In the current environment we have the benefit of the above approaches complementing signals from our rate of change approach.
Further confirmation of this comes from our Economic Adviser, Simon Ward, who recently wrote on the subject (MoneyMovesMarkets.com, "Has the Fed called the top in growth (again)?" January 19, 2022).
A sharp mean reversion from peak manufacturing PMIs is already in train and crucially, we have now passed the peak of the inventory cycle. Inventories boosted U.S. growth in Q4, contributing 4.9 percentage points to the headline real GDP data. GDP growth depends on the rate of change of stockbuilding (i.e., the second derivative). Stockbuilding may remain high in Q1, but as long as it is lower than Q4, it will contribute negatively to GDP growth.
U.S. Business Inventories Cycles Over Time
Source: Simon Ward, Economic Adviser, Refinitiv Datastream as at November 2021
Bond Markets Likely to Provide a Rude Awakening
The Fed seems blind to this slowdown, which is already in train, blaming any recent weakness on the Omicron variant of COVID‑19. Indeed, Chairman Powell struggled to articulate downside risks to the U.S. economy at his 26 January press conference, citing only further COVID variants.
In summary, none of what I have articulated in this note should be a surprise to our investors as it is process driven and forecastable in advance. We have laid out our thinking for many months and came into this year with a decade low level of interest rates sensitivity in our strategies, seeking to use an early 2022 rise in bond yields to look for opportunities to extend duration.
The kind of set‑up we have today, in which central banks are reacting aggressively – and late, to a sharp peak in coincident economic data, is the kind of opportunity that bond investors wait years to see. The consensus narrative of higher bond yields is overly focused on this lagging indicator and bond markets are likely to provide a rude awakening.
*Derivatives (in economics): the first derivative is the rate of change in a variable item, such as the rate of inflation (rate of change in prices of goods and services – see glossary). However, that rate of change may not be constant over time, hence the second derivative is used to show how the rate of change is changing over time.
Base effects: the impact of comparing current data/price levels in a given month against the price levels in the same month a year ago.
Bond yield: the level of income on a security, typically expressed as a percentage rate. Note, lower bond yields mean higher prices and vice versa.
Demand side: in simple terms, demand for goods and services within an economy (driving economic activity).
Cyclical: occurring in cycles – economies and markets are cyclical and the cycles can last from a few years to nearly a decade.
Goods cycle: referring in general terms to the goods producing industries’ (eg, manufacturing, construction and mining) growth.
Hawkish: (hawkish central bank language) refers to policymakers being more in favor of raising interest rates.
Hiking cycle: referring to a series of interest rate rises by a central bank.
Inflation: the rate at which the prices of goods and services are rising in an economy. The opposite of deflation.
Inventory cycle: inventory changes (restocking or destocking in the economy) can play an amplifier role in economic cycles. Here, referring to restocking/stockbuilding.
Lead indicator: economic or business statistics that are tracked from month to month and so indicate a pattern; useful in helping forecast the timing, magnitude and duration of future economic and business conditions. Leading indicators point towards future events, lagging indicators are seen as confirming a pattern that is in process and coincident indicators occur in real-time and clarify the state of the economy.
Mean reversion: a financial term for the assumption that an asset's price will tend to converge to the average price over time (i.e., long‑term level).
Reflation: here referring to an increase in economic activity, where the amount of money in use in the economy is increased.
Services cycle: in simple terms, referring to the growth and decline in the services industry.
Stagflation: A relatively rare situation where rising inflation coincides with anemic economic growth.