April 10, 2024
Audience: intermediate to advanced market knowledge.
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Do you know why investing in government bonds has failed to deliver a stronger performance in the past two years?
I mean, do you know why Treasuries or Bunds for example failed to appreciate consistently from their cheap valuations, despite the mantra repeated by any savvy investor out there that upcoming central bank cuts and fading inflation would have compressed bond yields big time?
You are lucky if you do.
No cuts, no party?
If we can definitely justify such lack of progress with a too-gentle slow-down of inflation (even if inflation is now fading faster in Europe - see a Linkedin post from our friend Gustavo), or eventually mention the perceived market uncertainty on how many rate cuts we will have in 2024 (the debate is still ongoing), we still do not know if government bonds will be a good investment going forward in the year.
With the US economy still growing faster than imagined, Europe picking-up again and the stock markets on fire, sudden and abundant rate cuts are not required. Bond yields have no clear reasons to suddenly and abundantly fall (and prices rise) then.
Best strategy so far
A good fixed income strategy so far in 2024 has been to focus the fixed income component of an investment portfolio on very short duration instruments (= debt instruments with shortest maturity).
In fact, we can see in the chart below that the US Treasury curve continues to pay investors much better on the very short end: if you look on the left-hand side of the chart, you will notice that current 3-month yields in US dollars pay close to 5.5% while investing in a US government bond over 10 years pays only 4.5% in USD terms.
Why would you risk your capital over 10 years against the risk of a US government collapsing and not repaying their debt back to you (improbable but possible) to receive 1% LESS income, if you can get 1% MORE income investing for three months?
An investor would be justified to invest in longer maturities only under the expectation of a major slow-down in the US economy, that would cause the Fed (in this case) to cut rates soon, pushing longer-dated Treasury yields down (and prices up). But has not happened so far.
Are rate cuts coming?
If you happened to travel around Europe, LatAm, Asia or the US to attend investment fairs in 2023 and 2024, you would have listened to many investment houses promoting their fixed income offering. Fixed income is cheap and it is the asset to buy, they would promise. Their bullish views on bonds would be explained by the Fed promising three interest rate cuts this year with the ECB following on the same path. Rate cuts = guaranteed bond performance.
Looking at the functions identifying investor expectations on upcoming rate changes (Fed fund futures for the US, EURIBOR futures for the EU), we can see below that markets continue to see three rate cuts in Europe in 2024 but only two (in September and eventually in December) by the Fed (notice the green triangles, indicating rate cuts).
These expectations are very important guides and keep changing on a daily basis. Let's ignore them for a second as rate cuts might or might not happen this year, either in the US or in Europe. We are instead here to report a more nuanced, less known and more controversial point.
No one is mentioning QT
Are you aware that both central banks continue to actively reduce their balance sheet with significant QT flows?
For the ones of you less familiar with QE or QT acronyms, you should know that some time ago the Fed and the ECB have started to actively sell, or let passively mature, all the bonds that they have purchased before or after Covid to support the liquidity of financial markets (an activity that went under the name of Quantitative easing or QE). Such balance sheet reduction, or reduction in the amount of bonds held by central banks, is equivalent to removing liquidity from markets (=removing support) and is called quantitative tightening, or QT, and it is the opposite of QE.
QT makes sense when economies overheat and when inflation goes ballistic (see 2022 or 2023). Does it make sense in 2024, as central banks keep announcing rate cuts to come?
First, let's see what is happening in Europe.
We can see that the light blue BARS in the above chart, on the extreme right, are below zero. These are the ongoing QT flows happening in the region since 2022 and until this past week-end (7 April 2024). The latest one has been the biggest negative QT flow ever in recent times. So QT is going on at full speed, meaning that a sort of monetary tightening remains in place in Europe. Are you surprised now that European government bonds have not performed as desired in 2023 and 2024, despite the ongoing promise of rate cuts?
The chart shows also a greenish area, indicating the size of the ECB balance sheet. We can see that recent QT flows are in fact reducing such balance sheet.
In other words, while everyone was waiting for bond yields to compress and prices to skyrocket, given the ongoing suggestion of rate cuts, reality has been different. Yes, higher-than-expected inflation did not help bonds in Europe in 2023 and in this early part of 2024, but probably the above-mentioned, significant and ongoing QT in Europe (equal to monetary tightening, the opposite of the expected pre-announced easing) is the main reason why bond yields have disappointed. If this activity continues, I am not sure longer duration bonds will do well in Europe in 2024 at all.
QT is ongoing in the US too, driving the Fed´s balance sheet down - see below.
To be fair, the biggest negative flows are in the past (differently than Europe) but QT remains in place.
Can QT and rate cuts co-exist?
The big question is: what's the point of promising and eventually running rate cuts (to ease monetary policy) from summer 2024, if QT (equivalent to tightening monetary policy) remains in place?
No one knows. Central banks seem to say yes: more insights from the FT here.
My humble opinion is that investing in fixed income continues to make sense only without (or with very limited) duration exposure, or buying very short maturities paying a high income with negligible sensitivity to changes in interest rates.
Share your thoughts with us: hello@pantar.ai. We will publish your answers if you are happy for us to do so!
