Why I’m getting excited about bonds for the first time in years

The author is Chief Market Strategist for Europe, Middle East and Africa at JPMorgan Asset Management

For the first time in well over a decade, I’m starting to get excited about bonds. This marks a definite turnaround in my enthusiasm. For years I felt the bond market was terribly mispriced.

Never more than at the beginning of this year. Inflation was rising, central banks were still blindly assuming inflation was temporary, and governments seemed to have lost their fear of debt. And yet the yield on 10-year government bonds was 1 percent in Great Britain, 1.5 percent in the USA and a whopping minus 0.2 percent in Germany.

Corporate bond pricing has been similarly confusing. Investment grade companies collectively offered only a fraction of the excess return above the ridiculously low levels in government bond markets. With yields around 3 percent in Europe, the term “high yield” was frankly ridiculous. At one point nearly a third of the bonds in the Barclays Global Aggregate Index had negative yields and the term ‘fixed income’ seemed a contradiction in terms.

The problem was that investors and central bankers had bought into the long-low narrative and the idea that inflation and growth were persistently low for structural reasons. A consensus formed on the view that growth would always be lackluster due to poor demographics and productivity. And that inflation would be curbed forever by forces like globalization and the internet. It was assumed that in their vain pursuit of 2 percent inflation, central banks would have no choice but to keep interest rates low.

The lack of inflation also led to the assumption that central banks would always be able to buy bonds to avoid episodes of financial volatility. Investors no longer demanded high risk premiums, knowing full well that central banks would take assets from them in difficult times.

All of that turned out to be wrong. It is now perfectly clear that developed world economies can generate inflation. And not just because they’re being hit by cost shocks – we can generate inflation domestically.

Former Federal Reserve Chairman and newly crowned Nobel laureate Ben Bernanke has finally had his “helicopter” theory confirmed. This term was adopted from a great speech he delivered in 2002. In that speech he not only used the (in my opinion) underused term willy-onilly, but also argued that “under a fiat money system, determined government can generate ever-increasing spending and therefore positive inflation “. We now know that this is true.

The bond market has undergone a brutal re-evaluation. Markets have had to completely reconsider the outlook for central bank interest rates and the risk premium that should exist in a world where central banks cannot support the market.

Some may argue that the Bank of England’s recent interventions in the gilt market show that the central bank’s ‘put’ is still there. But the bank has stressed that this support is temporary and for the sake of its inflationary mandate it must return to its plans to trim its balance sheet next month. The new risk premiums are still there. The 30-year UK government bond is up more than 3 percentage points from where it started the year.

The correction in global bond markets, while painful, is nearing completion. In all likelihood, we will not return to a period of extremely low growth or inflation, nor will we enter a sustained period of out-of-control inflation.

Inflation, led by the US, is likely to moderate in the coming months in response to weaker economic activity. But I don’t expect the economy to collapse, showing its ability to withstand slightly higher interest rates than in the past. The 10-year Treasury yield should be 4 percent, in my view, a level the market broke late last month.

If I’m right, global bond prices are looking really tempting. Just look at the level of customization we’ve seen. The global government bond benchmark is now yielding 3% versus 1% at the start of the year, global investment grade yields are now yielding over 5% versus less than 2%, and global high yield is once again worthy of such a name with a yield of nearly 10 percent.

“No pain, no gain” is a saying that’s as frustrating about getting fit as it is about commitments. But after the pain of 2022, there’s scope for decent gains.