The recent surge of inflation is no friend to the bond market. As Treasury yields have risen, prices have dropped as investors price in expectations that the Federal Reserve is preparing for the start of what some say will be an extended run of rate hikes, beginning with the March. 16 FOMC policy announcement.
The eurozone is thought to be further behind the Fed in terms of plans to lift rates, but the luxury of standing pat may be set to end soon for the currency bloc. A new Reuters poll of economists reports points to expectations for a rate hike in the second half of the year.
The Bank of England, meanwhile, has already raised its policy rate twice in the past two months and more increases are expected after today’s news that UK inflation held at a 30-year high in January.
With no place to hide, fixed-income investors are pondering their options. The standard investment-grade bond benchmark for the US certainly looks challenged. Vanguard Total Bond Market ETF (BND) has fallen almost continually for much of the past two months and it’s not obvious that the rout is about to end.
The formerly high-flying junk bond market isn’t doing much better, based on SPDR Barclays High Yield Bond ETF (JNK).
The trend looks even worse for unhedged foreign government bonds in developed markets from a US-dollar-investor perspective.
Hedging foreign currency exposure doesn’t help either.
Are there any corners of the global bond market that offer a rosier outlook? Yes, or at least maybe. Emerging markets bonds in local currency terms have become an upside outlier in the great selloff that’s otherwise weighing on fixed-income portfolios. VanEck JP Morgan EM Local Currency Bond (EMLC) has been modestly but persistently trending higher since December. Year to date, EMLC is up 2.3% vs. a 4.0% loss for the US benchmark (BND).
Within the emerging markets space, China fixed income continues to catch a bid. VanEck Vectors ChinaAMC China Bond (CBON) so far this year has added 1.4% in total return.
What’s driving CBON higher? China’s economy appears to be in a much different place vis-a-vis inflation vs. developed markets in the West. For example, factory-gate inflation in January eased to a six-month low. To be sure, the producer price index is still high, but a 9.1% year-over-year increase last month was well below December’s 10.3% gain and moving in the right direction. As a result, the downside bias for pricing pressure stands in sharp contrast with the US.
By some accounts, additional interest rate cuts in China are a reasonable forecast. “Inflation concerns are unlikely to hold back the [People's Bank of China] from more policy loosening measures,” says Sheana Yue, China Economist at Capital Economics. Adds Zhiwei Zhang, chief economist at Pinpoint Asset Management: “Lower inflation reflects the weak domestic demand.”
China’s 10-year government bond yield is on board with that analysis. The country’s benchmark rate today is trading at roughly 2.8%, close to a year-and-half low.
Bonds issued by China and other emerging markets come with a unique set of risks, of course. And assuming US rates continue to rise, the relative allure of higher yields in China will fade, possibly creating a new risk factor down the road. There is also a variety of geopolitical risk factors to consider, particularly with China. Add in foreign currency volatility to the mix and it’s clear that investors need to think carefully before diversifying beyond traditional safe havens in bond-land.
But as any US-focused bond investor will tell you, Treasuries aren’t exactly risk-free either these days. ■