The Global Bond Market Rally Fizzles Out

The record-breaking global bond market rally that began in early 2023 has abruptly stopped due to mounting signs of persistent inflation. Investors had been expecting the US Federal Reserve and other central banks to end their aggressive campaign of monetary policy tightening. Still, better-than-expected economic data points on both sides of the Atlantic have upended this optimism. As a result, bond yields have risen, upsetting the stock market rally and causing investors to reverse their views on the likely future path of interest rate increases.

The Reality Check

A Bloomberg index tracking high-grade government and corporate bonds rose as much as 4 percent last month, its best start to the year. However, this gain has disappeared after a scorching US labor market report kicked off a run of better-than-expected economic data earlier this month. This has caused investors to reverse their views on the likely future interest rate rise path. Michael Metcalfe, head of the macro strategy at State Street, stated that the easing of monetary policy expected by markets a few weeks ago “looked a little fanciful.”

The US Federal Reserve’s Response

The most significant reversal occurred in the US after data showed that employers added more than half a million jobs in January and that consumer price growth stood at 6.4 percent — above projections. On Friday, the Fed’s preferred price growth gauge — core monthly personal consumption expenditure — rose 0.6 percent from December to January, higher than consensus forecasts. Futures markets, which had previously reflected bets that the US central bank would reduce interest rates twice later this year, now predict that rates will rise to 5.4 percent by July, with at most a single cut by the end of the year.

The Impact on Stock Markets

The resulting rise in bond yields has also upset a rally in the stock market, with the S&P 500 losing 2.7 percent in the past week. Idanna Appio, a portfolio manager at First Eagle Investment Management, noted that investors were betting that the Fed would get inflation down successfully and quickly but that “this process is going to take longer than people thought.”

The reversal in Bond Fund Flows

The shift in sentiment has also been reflected in bond fund flows, with the most significant reversal coming in the riskier end of the credit spectrum. According to JPMorgan data, emerging market bonds, which soared in January, this week saw the most significant outflows since October. Globally, more than $7bn has leaked out of “junk” rated corporate bond funds in February, according to data from EPFR, after net inflows of $3.9bn in January. This is because investors demand a higher premium to hold high-yield, low-rated corporate debt than last month when market ebullience diminished concerns about debt defaults.

Related Facts

• A Bloomberg index tracking high-grade government and corporate bonds rose as much as 4 percent last month, its best-start to the year.
• Futures markets, which had previously reflected bets that the US central bank would reduce interest rates twice later this year, now predict that rates will rise to 5.4 percent by July.
• The S&P 500 has lost 2.7 percent in the past week.
• Emerging market bonds, which soared in January, this week saw the most significant outflows since October.
• More than $7bn has leaked out of “junk” rated corporate bond funds in February.

Key Takeaway

The record-breaking global bond market rally that began in early 2023 has abruptly stopped due to mounting signs of persistent inflation. This has caused investors to reverse their views on the likely future path of interest rate rises, resulting in a reversal of bond fund flows and a downturn in the stock market rally. The US Federal Reserve is expected to raise interest rates to 5.4 percent by July, with at most a single cut by the end of the year.

Conclusion

The sudden reversal in the global bond market rally has shocked investors who had become increasingly optimistic that the US Federal Reserve and other central banks would soon end their aggressive campaign of monetary policy tightening. However, the recent better-than-expected economic data has caused investors to reassess their expectations, resulting in a rise in bond yields and a downturn in the stock market. How the markets will respond in the coming weeks and months remains to be seen.