5 Factors to Understand What’s Happening in the Fixed-Income Market

Marco Giordano, Fixed Income Investment Director at Wellington Management

These are the aspects that, in our view, are behind the latest movements in the fixed income market. 

We close 2023 by analysing the factors that have been key to understanding the performance of fixed income in recent months: the market rally, economic data, the brake on German debt, the movements of emerging market central banks and consumer resilience. Below, we explain why we consider them relevant:

1) Market rally. During the month, fixed income markets saw a significant rally, with yields on sovereign bonds declining sharply, signaling a stunning turnaround from the end of October and marking the best one-month returns in global fixed income since 2008. Key drivers of the rate move included the following:

• Communications from the Federal Reserve (Fed) and other central banks reiterating the belief that inflation was on its way back to more normalized levels and that financial conditions were already tight, with monetary policy appropriately restrictive. The market interpreted these statements as an indication that additional rate hikes were likely off the table and repriced 2024 rate cuts. Remarkably, a rate cut by the Fed is now expected as soon as March/April.
• Inflation data supported central bank forecasts. The global rally in rates markets was initially triggered by US core and headline CPI coming in below expectations. Headline inflation in the Euro Area came in at 2.4%, a full 0.5% below expectations and the lowest point since July 2021.
• A plethora of other data indicated a cooling global economy, once again led by the US, including ISM (both services and manufacturing), fading consumer confidence, non-farm payrolls, and initial jobless claims.
• Short covering by investors who were positioned short duration accelerated this trend.

While many yield curves remain inverted, we witnessed a flattening as the rally was more pronounced in long-end bonds. For some return perspective, the duration of the on-the-run 30-year US Treasury bond is just over 16 years, and its yield fell ~60 basis points, translating into a 9.7% price return. We have also seen a selloff in the US dollar (USD) as markets begin to price the path of USD rates moving lower relative to a basket of other developed market currencies.

2) Economic data. The latest data suggests that while economies are weakening, they are doing so slowly and cycles are finding a floor. Core goods inflation in the US has fully normalized and manufacturing ISM remained below 50, proving that tightening financial conditions are starting to bite. In Europe, broad-based declines in inflation have been driven by falling energy prices but also an ongoing slowdown in the economic cycle, particularly manufacturing. Despite European manufacturing PMIs remaining in contraction territory, most countries saw a lift in November and leads are suggesting the cycle may have troughed over the summer, with early signs consumer confidence and industrial order from China are picking up. Core inflation remains comfortably above target, as services PMIs exceeded expectations and labour markets remain very resilient with unemployment only slightly ticking up.

3) German debt brake. In mid-November, Germany’s constitutional court determined the government’s transfer of €60bn to the Climate Fund from the Covid Fund, as well as the broader use of special purpose vehicles (SPVs) to circumvent the debt brake, was unconstitutional. The immediate impact of the ruling is that fiscal policy will be less expansionary in the next few years, and reduces the expected issuance of bunds going forward, as the government must reduce its fiscal commitments or find other ways of financing them. Germany has a constitutional debt brake rule which prevents it from running structural budget deficits above 0.35% of GDP – we don’t expect the court’s ruling to be reversed or the debt brake removed in this parliament, but it does constrain fiscal spending for the time being. This makes it more difficult for Germany to address structural challenges and shift its economic model away from exports towards domestic consumption.

4) Emerging markets’ central banks have been successful in frontloading hikes during this cycle, putting them in an enviable (for other policymakers) position to gradually bring down rates, supporting the economy without the risk of entrenching inflation in the system. In fact, a number of countries find themselves ahead of the US in being able to ease policy, with Latin America and central Europe leading the way, as Brazil and Hungary cut rates by 50bps and 75bps respectively in November. The notable outlier remains Turkey, which continues to see jumbo rate hikes in an attempt to curb runaway inflation. In this context, EM FX should in theory struggle forward not only because of these rate cuts, but also because end of cycle dynamics generally favour the greenback, Swiss Franc and Japanese Yen as safe haven assets. However, the carry trade – where investors borrow in currencies with low rates to invest in higher yielding currencies – has been a very successful strategy this year and could continue to be so for some time.

5) Consumer resilience. A significant driver of persistent economic growth and services inflation over the past 12 months, the consumer has surprised most expectations to the upside. Since the global financial crisis, we have seen a persistent deleveraging of balance sheets: combined with the shielding by governments in the Covid and energy crises of the last few years, consumers enter this phase of the cycle from a position of remarkable strength.

Wage growth has supported incomes in the face of rising inflation, and while there are concerns about an incoming recession, this does not appear to be consumer-led. Excess savings accumulated during Covid have been broadly depleted in the US, but not in Europe, where savings rates remain higher than they were prior to the pandemic. Credit card delinquencies have ticked up recently but remain a far cry from the levels seen in the run-up and wake of the global financial crisis, when readings breached 3%.