By Nikolaj Schmidt, Chief International Economist, T. Rowe Price.
Recently, we have seen the 10-year US government bond rise above 5 per cent again, while a 30-year mortgage in the US has reached 8 per cent. The market expects that the high interest rate levels created by the historically aggressive rate hikes of recent years will be around for longer than previously thought.
This development has also meant that bonds have once again become the subject of interest among investors. For a number of years, it seemed that there was no real alternative to the stock market when it came to investing. However, equities and bonds are not two independent entities. If we are to understand the outlook for the stock market, it is necessary to look at the bond market to get a sense of where we are heading.
Bond market turmoil
Both last year and this year, we have witnessed turmoil and corrections in the bond market. While the downturn in 2022 took place against a backdrop of soaring inflation and accelerated monetary tightening, 2023 was a different story. Bond market developments this year have been characterised by more moderate inflation and central banks increasingly signalling that they are at, or close to, the end of the tightening cycle.
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There are two main lessons to be learnt from the bond market developments of recent years. Firstly, in 2022, we saw a slowdown in economic activity signalling that central banks were slowing down the economy and that they would have to quickly turn around and drastically cut interest rates once a recession had occurred. Since then, the development in the key figures has changed the market narrative: The market now believes that the US economy, and the world as a whole, can function just fine with a key interest rate above 5 per cent. This has led to a reassessment of the key interest rate, which the market expects to apply in the long term.
The improvement in the key figures has led central banks to signal that they will not ease monetary policy in the near future. This has naturally strengthened the market narrative and resulted in a correction in the bond market.
Lesson number two is that high interest rates and economic developments have changed the supply of government bonds. In recent years, governments around the world have seen interest costs rise, creating larger budget deficits that need to be covered. This has been done by issuing more bonds. At the same time, we are seeing reduced demand as a result of the shift from quantitative easing to quantitative tightening. Central banks have gone from being big buyers of bonds to big sellers. As a result, the market has been flooded with a huge supply of government bonds that others have been reluctant to buy.
What do bond market corrections mean for the economy?
To assess how the current bond market downturn is affecting the economy, it is necessary to look at whether the current market pricing of monetary policy is consistent with the underlying economic dynamics.
In my view, the market’s perception that the US and global economy can function well with a US policy rate of more than 5 percent is a gross misunderstanding of the current economic dynamics.
As such, I believe that the recent bond market downturn is out of step with policy rates and will prove to be very damaging to the global economy.
My logic is this: the resurgence in economic activity we saw in 2023 is the result of temporary factors and they are fading. These factors reflect a cyclical recovery in demand for services that has been made possible by an easing of financial conditions and the use of financial stimuli provided during the pandemic. The crux of my argument is that in response to slowing inflation in the US, the reopening of the Chinese economy and the rapid disappearance of the energy crisis in the eurozone, financial conditions were significantly eased in Q4 2022.
With the usual 6-month lag, this easing of financial conditions provided a large positive impulse to growth. Unfortunately, with the downturn in the bond market and the associated rise in the US dollar and fall in equities, the positive growth impulse is fading and will develop into a headwind for growth.
Stocks are facing a correction
In the very short term, I expect us to continue as we have so far. This is because encouraging economic data continues to keep central banks under pressure to keep monetary policy tight, but within 3-6 months, I expect that both the US and other central banks will realise that the reality of US interest rates exceeding 5% is seriously damaging economies. We will see a significant slowdown in growth and this will affect the stock markets.
My assessment is therefore that even though we will initially see risk assets such as equities benefiting from the bond market’s recovery, it will slow down in the longer term and a correction will be the scenario. On the positive side, central banks have now raised interest rates so much that they will be able to cut rates in response to a slowdown in growth, but my assessment is that central bank easing will only follow a significant correction in risk assets. And while this correction unfolds, we will see demand for bonds increase. This will bring the current imbalance between supply and demand for bonds into better balance.
Again, the US is expected to be in a better position to withstand the pressure of higher interest rates, and therefore I expect US assets may be poised to continue to outperform the rest of the world.
