Active Thinking: The great rates market sell-off: What now?

Many market commentators and money managers have been recommending going long interest rate duration for months now – but markets have shown no sign of turning in their favour yet. Indeed, we may still not be done, argues Ralph Gasser, Head of Fixed Income Investment Specialists.

30 October 2023

Being long interest rate duration risk used to be a profitable business. Not anymore. In fact, the market yields correction that commenced in earnest at the start of 2022 has since turned into the worst drawdown in terms of nominal total returns since the late 18th century.

Looking at the benchmark 10-year US Treasury bond, for instance, 2022 was its annus horribilis, with the annual total return – the combination of yield carry and market price change – coming in at an unprecedented -16.3%. And with rates markets continuing to sell off this year, three-year rolling total returns now print at -24.5% (as of 25-Oct-23), a drawdown more than twice as bad as the worst corresponding period in history. This picture does not look too dissimilar elsewhere, namely across most of the advanced economies.

The worst nominal return drawdown period for interest rate risk since the late 18th century

Looking at the drivers behind this selloff, we can break up nominal yields into their underlying subcomponents; breakeven rates, i.e. market-implied inflation expectations derived from same duration inflation-linked bonds, and residual real rates.

As illustrated below, fast-rising inflation expectations reflected via breakeven rates were the dominant force behind nominal rates in 2020. But this was largely offset by still-declining real rates. This changed dramatically at the start of 2022, however, and while 10-year breakeven rates settled within a 2.25% to 2.5% range, real rates surged by more than 3.5% since the start of 2022 and still show no signs turning.

The look behind the scenes – Breaking up nominal yields into their subcomponents

But why this blowout in real rates? And what should we expect from here?

In theory, and very broadly speaking, the real rate should be the rate at which inflation is kept at target and the economy operates at full employment – neither expansionary nor contractionary. In practice, and largely reflecting this, real interest rates across maturities and most advanced economies have been in steady decline since the mid-1980s, which was supercharged by the various extraordinary monetary policy measures introduced by central banks ever since the global financial crisis.

But times have changed. Most crucially, central banks’ monetary policy has tightened aggressively since 2022 in response to uncomfortably high inflation, both by raising headline rates and by starting to run down the massive bond holdings accumulated over previous quantitative easing (QE) programmes.

The reversal of real interest rates – Central banks’ aggressive monetary policy tightening

Given the extreme correction we have seen in real interest rates, and with it, nominal rates, are we back to fair value today, with calmer waters ahead?

If we take it that the drivers behind real interest rates are broadly similar to those driving economic activity, the answer at first sight would most probably be “yes”. Real rates are at last back to real GDP growth rates, as they used to be for most of times before the extraordinary monetary policy measures introduced by central banks. This “yes”, however, implies that the current consensus market forecasts on real and nominal economic growth are correct and that valuations are purely driven by fundamentals – which we all know is most of the time not the case.

The realignment of real interest rates with fundamentals

Indeed, in my view, there are still plenty of headwinds ahead for both real and nominal yields. To name just a few, there is plenty of surprise potential attached to current economic forecasts, both to the up- and downside in a world of fragile geopolitics. Also, central banks in the West may be largely done with hiking rates but running down the massive bond holdings accumulated over previous QE programmes is not. This removes a central marginal buyer of core market bonds.

In addition, the US government is set to run an annual budget deficit of around -6% of GDP each year for the next three years, almost double the typical structural run rate of -3% to -3.5%. On top, heavy refinancing of existing government and corporate bonds will hit bond markets in 2024, all searching for a bid at the same time. And lastly, in a higher-for-longer short-term rates environment, the record amounts of cash today held in short-term products will have to be lured out the curve to meet these huge financing demands, which will require positive not negative term premiums, and an end to inverted interest rate structures.

All these factors do not support a decline in real rates anytime soon – rather the opposite. If we add that core inflation remains sticky and deflationary base effects of food and energy prices are already waining fast, breakevens, too, may be subject to upside surprises from here.

So while being long interest rate duration risk may at first sight appear to be a profitable business again, a more sober perspective, particularly on old-fashioned supply and demand dynamics, suggests otherwise. At least today’s yield carry returns do provide for some comfort.