The current bull market in bonds has a tough act to follow. After all, its predecessor lasted 40 years.
Yet Sir John Templeton’s famous analysis that bull markets in equities are “born on pessimism, grown on skepticism, mature on optimism, and die on euphoria,” may have some parallels in the fixed-income markets. No one expects a replay of the 1981-2022 downhill run that began with sky-high 15% to 20% interest rates in the early 1980s and fell to near zero or negative levels in some nations in the last decade.
Instead, some, like Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income, think the bond market is in the early innings of a bull market that is likely to look more normal than the previous marathon cycle. The Covid-19 pandemic and its aftermath, with the first serious burst of inflation in 40 years, prompted a reset of interest rates at a “very reasonable” level, rising above 4%.
Some key rates, like the federal funds rate and the yield on 30-year Treasury bonds, have actually gone further and topped 5%. The fed funds rate stayed there for almost 14 months. For investors with long memories, the chance to lock in Treasury yields topping 5% seemed like a flashback to another era.
Sudden and dramatic interest rate swings can cause investor behavior to shift. Near-zero rates in the previous decade acted as an aphrodisiac prompting Americans’ love affair with stocks to bubble over while consigning bonds to the position of wallflower in most people’s portfolios.
Ever since the Fed began raising rates in early 2022, people have begun noticing the yields on money market funds and CDs too—while they’ve been groaning at mortgage rates. “Yield is destiny,” Tipp says.
Suddenly, equities face at least a hint of competition. According to the Investment Company Institute, $6.47 trillion sat in money market funds as of October 10. Tipp expects a lot of that money to move into fixed-income securities.
Falling interest rates are almost always good news for bonds, but they are usually associated with a moderating economy. While it’s not yet clear whether the U.S. economy is actually slowing or normalizing, it is clear that the impact of the huge fiscal and monetary pandemic stimulus is finally fading. It’s too early to anoint Fed chair Jerome Powell as a maestro—the moniker given to ex-chair Alan Greenspan after he engineered a soft landing in the mid-1990s. Powell was painfully slow to realize that the latest bout of inflation wasn’t transitory. But the central bank has managed to raise rates faster than any Fed leader since Paul Volcker while avoiding a recession. And for now, inflation appears neutralized.
Inflation Normalizing
In an October 9 note to clients, Pimco’s managing director Tiffany Wilding and global fixed-income CIO Andrew Balls wrote, “The factors that supported relative U.S. economic strength are diminishing. That suggests some recoupling with the rest of the world and further progress on curbing inflation.”
In much of the developed world, inflation appears to be returning to targets, as consumer demand normalizes and competition for “limited job openings” increases, the Pimco executives wrote. Even in the U.S., labor markets suddenly appear looser than they were in 2019 before the pandemic destabilized employment conditions. This has been underscored by the 1% uptick in the unemployment rate in the last year.
One major surprise from the monetary tightening cycle that began in early 2022 is that central banks have managed to raise rates aggressively without triggering a recession. That’s partly because of the massive stimulus policies of the pandemic.
But it also demonstrates the increasing impotency of monetary policy. Like an antibiotic that gets overprescribed, it appears to have lost some of its efficacy. Another factor limiting the effectiveness of monetary policy is existing homeownership. Despite the pain of higher rates, many people aren’t affected: An estimated 38% of Americans own their homes mortgage-free, while millions of others were already locked in low-rate mortgages before interest rates rose.
“Higher rates don’t necessarily cause a recession, but they hurt,” Tipp says. “This is an economy driven by job growth, not interest rates.”
A recession isn’t off the table, but most senior fixed-income investors like Tipp, Wilding and Balls see a soft landing as a more likely scenario. Tipp expects central banks to play it cautious and try to extend the expansion. “Things are likely to get better than worse,” he says.
Meanwhile, there is a growing consensus that as the Fed and other central banks lower rates the yield curve will steepen. This typically creates a favorable environment for fixed-income investments, Wilding and Balls maintain.
Bond market professionals would appear to be living in a near-perfect world after the bear market of 2022. But there’s one problem: The market itself is already pricing in expectations of a favorable environment, leaving many fixed-income securities vulnerable to short-term setbacks, like the strong unemployment report in early October. As expectations change, volatility rises. And the monthly data in both inflation and unemployment is erratic at a time when many of the strong returns have already been earned from coupons this year. That’s why the capital appreciation of bonds has bounced around in 2024.
It also explains why Tipp expects bond prices and yields to be range-bound for the next 12 to 18 months. The Fed itself has changed its estimate for the fed funds rate. Recently it was 4.2%. Earlier, when the economy was looking weaker, it was 3.4%. “Our best estimate is 3.4%,” Tipp says.
One contrarian who thinks the economy is already in a recession is Jeffrey Gundlach, the CEO of DoubleLine. Speaking on a webcast in early September, he said that by September 2025 economists would realize the economy had been in a recession for at least 12 months.
Like many others, Gundlach believes the Fed waited too long to cut interest rates and now thinks the central bank should cut the fed funds rate eight times, or by about 2 percentage points, and that the cuts should come sooner rather than later. Tipp estimates that there will be six cuts by the Fed, which has 10 meetings between now and the end of 2025.
Many fixed-income experts think inflation has been subdued for the foreseeable future, but Dan Fuss, the vice chairman of Loomis Sayles, has his doubts. He thinks the potential for either higher tariffs or taxes in the next administration could spur businesses to raise prices. Furthermore, climate change is curtailing the availability of certain goods—the supply of homes in Florida and North Carolina just shrunk meaningfully, and the construction workers who might have built new houses are likely being diverted to rebuild existing residences. Meanwhile, the geopolitical crises in the Ukraine, the Middle East and potentially the South China Sea are not the kind of developments that are going to help ease inflation.
What about the internal dynamics of different sectors of the bond market? In a virtual meeting with financial advisors and other clients on October 2, Vanguard Group’s global head of fixed income, Sara Devereux, spelled out the firm’s tactical strategies in detail.
Vanguard is favoring late-cycle trades and long duration bonds, she said. As of early October, she indicated the firm was using a “yield-curve steepener,” basically a bet that short interest rates would fall faster than long rates.
In the credit markets, “fundamentals and earnings have been very strong,” she continued. Furthermore, the “default cycle is muted, but we are late cycle. We want to have dry powder.”
Spreads, the yield differential between Treasurys and corporate bonds of similar maturities, are historically tight. The demand for additional yield is formidable. Despite the strong fundamentals on corporate balance sheets, Tipp says bond issuers have been wary because they are spooked by the non-stop predictions of a recession for the last three years.
The Elephant In The Room
One issue that continues to alarm many advisors’ clients is the federal budget deficits of $1.8 trillion. The pandemic is over, and the economy is relatively strong; we’re at a point in the business cycle when common sense says it’s prudent to limit debt growth. One can only estimate what the deficit would look like if recession struck.
That trajectory is unsustainable, yet neither candidate addressed the topic in a serious fashion during the 2024 campaign for the U.S. presidency. Former President Trump said he would eliminate taxes on Social Security, though they are currently paid only by seniors with outside income. The date when Social Security recipients will have to take a 21% reduction to their benefits is now only a decade away. Medicare’s problems are even more intractable. In all likelihood, the entitlements crisis will become a major political issue in the next presidential election cycle in 2028.
But if politicians are ignoring the looming entitlements shortfall, the bond market is almost as oblivious. Gundlach has said several times that when the next recession strikes and the Federal Reserve slashes interest rates, at the same time the federal deficit climbs toward $3 trillion, he would not be surprised if long-term rates defied past recession experiences and actually rose as investors questioned the reliability of long-term financial promises.
But intuitive expectations don’t always materialize. Lacy Hunt, the chief economist of Hoisington Investments, has studied Japan’s experience with aging demographics and the accumulation of government debt over 30 years. The results are somewhat counterintuitive.
As Japan issued more and more debt, the “marginal revenue product of debt fell” as the multiplier effect of each additional dollar of debt actually went negative, Hunt explains. That’s the opposite of what Keynesian economics contends. But in contrast to what one might expect, deflation, not inflation, took over the nation and economic growth declined and struggled to stay in positive territory.
America has more favorable demographics, so the parallels are somewhat different, if not encouraging. As U.S. government debt went from $5.6 trillion in 2000 to $21.6 trillion in 2020, Hunt says its trend line GDP growth declined from 2.0% to 1.3%. That’s a 35% decline.
What was different during the pandemic was that fiscal and monetary policy were coordinated “like never before,” Hunt continues. Unlike the quantitative easing policies of former Fed chair Ben Bernanke, which Hunt maintains fell within the confines of the Federal Reserve Act, Powell ignored many of the rules set forth by politicians in 1913 (the year the law was enacted). There was “a huge expansion of money in 2020 and 2021 and a huge contraction since then,” Hunt says, adding it’s a surefire formula to generate inflation.
Would the Fed do it again? If it doesn’t, Hunt expects the inflationary trend in the U.S. to be downward. And for now, the U.S. and many other developed nations have experienced increases in excess capacity and decreases in the average workweek.
In his view, wave after wave of monetary and fiscal stimulus simply inflates asset prices, exacerbating wealth disparities and social discord. The “consequences for people in the bottom 8 deciles [of the wealth spectrum] is very hard,” he observes.
Not everyone is so pessimistic. For most of the 40 years PGIM’s Tipp has been managing assets, he’s heard very intelligent people depict apocalyptic scenarios about America’s chronic budget deficits and burgeoning debt. These conditions are hardly optimal, but they haven’t been a huge headwind either.
Waiting for a disaster isn’t particularly helpful, in Tipp’s view. “There is a certain amount [of money] people want to save, and interest rates affect that to some extent,” he says.
Developed nations enjoy certain luxuries that emerging nations don’t, he argues. For instance, in the U.S. and other mature nations, corporations and households have been relatively prudent borrowers, while governments have been more aggressive, but these nations have displayed an ability to shift excess borrowing between the private and public sectors. That’s why they are less likely to experience the vicious cycles endured by developing nations, where investors attack their currency and debt, causing capital to flee.
Still, how this plays out for the U.S. remains to be seen. Both Gundlach and Fuss expect the dollar to suffer a substantial decline in the next decade. And that alone will cause inflation in certain goods to stage a comeback.