7Q: Further money tightening predicted for 2023 bond market

Daniel Antoniou, Executive Director and Head of Asset Management at 7Q Financial Services Ltd, explains how the US bond market has become what it is today and reveals his expectations for 2023.

In 2022, the US bond market turned in its worst-ever performance. What was behind this?

There is a simple rule of thumb which states that when economic conditions cause interest rates to rise, the value (or price) of fixed rate bonds will fall, because new investors will demand a higher rate of return to match the new interest rate environment. Under the threat of inflation, central banks around the world responded by raising interest rates in 2022, and this has caused a massive repricing downwards of the value of fixed rate bonds.

So, what is behind all this, and what can be expected for the future? Since the early 1980s, global bonds (including US bonds) have experienced a supercycle, during which their annual rate of return (commonly called the yield) declined to zero. Such was the intensity of this supercycle that bond yields started falling below zero in 2014 and, at its peak, more than US$17 trillion of global debt was offering negative yield to investors. The fuel for this supercycle was rapidly declining global inflation rates. Such a dramatic reduction was made possible because of aggressive inflation-fighting central banks in the early 1980s and ’90s, the rapid industrialization of China, the exponential rise of technology in supply chains, and favourable global demographics. This narrative is now starting to unwind. Since 2016 or so, we have witnessed a secular reversal of these deflationary trends. Globalization is retreating, as geopolitical conflicts and trade protectionism top the global political agenda. Demographics have also turned, as populations age and the global workforce declines. Adding the capital costs associated with the transition to clean energy, global economies are now faced with significant inflation pressures, which are structural in nature. Significant inflation pressures arise also from the expansionary monetary and fiscal policies followed over the last 10 years or so. During this period, central banks have engaged in large scale printing of money (quantitative easing) and governments have spent without restraint. During 2022, global inflation rates soared much higher than the optimum target set by central banks of about 2%. Central banks have no option but to increase interest rates and shrink their enormous balance sheets because their mandate, above all, is to ensure price stability. The fuel of the near 40-year bond supercycle seems to have run out.

How would you describe the investment outlook for bonds in 2023?

The outlook for 2023 is one of further monetary tightening. Although global inflation rates peaked in late 2022 (US inflation peaked at 9.10% versus 6.50% now, and EU inflation peaked at 10.60% versus 9.20% now), they are still way above the optimum target of about 2%. Various theoretical models also suggest that current interest rate levels should be much higher. Considering also that central bank balance sheets will have to shrink further, monetary decisions will greatly influence market momentum in 2023. Against this backdrop, we expect demand for bonds in circulation (and new issues) to be relatively strong as nominal yields are now significantly higher than zero. Supply will likely tighten as issuers will be less willing to take up debt at a higher cost. 2023 will probably be a volatile year and active traders will try to time their entry and exit from positions. On the other hand, this volatility will create buying opportunities for longer term or buy-to-hold investors who may want to start partially allocating their available capital. However, real returns will remain negative throughout 2023.

What kind of bonds are of most interest to investors?

European and US Government bonds are very important to investors because they reflect EUR and USD risk-free rates at different timeframes and, by extension, they are used as the benchmark (or discount rate) for every other investment decision.

Can you suggest specific bonds that you believe will perform best in 2023?

I will refrain from specific suggestions as the suitability and appropriateness of any suggestion differs from person to person. However, I can offer my general view on which segments of the fixed income market can outperform in 2023. As we are at the very start of this inflationary cycle, short durations are preferred. The increased cost of debt will destabilize corporate balance sheets and, for this reason, high quality issuers are preferred. My picks for 2023 are Government T-bills (of any duration up to 12 months) and Investment Grade corporate issuers with duration up to 36 months.

(This interview first appeared in the February 2023 issue of GOLD magazine. Click here to view it.)