Financial markets - 01/2023

Is it a good time to invest in bonds?

By Laurence De Munter

2022 was a year where a perfect storm hit fixed income markets. This storm has been brewing for a long time as bond yields have been falling for several decades to record lows. In Europe,bonds were even issued at negative yields. Moreover, the duration of fixed income benchmarks had increased over time, increasing the sensitivity to interest rates. As a consequence, the rapid and aggressive interest rate rises caused havoc in bond markets. In the US alone, the FED announced three 75bps hikes in a period of only 4 months in order to curb inflation pressures. 2022 will be remembered by many as an annus horribilis. As we embark on a new year, we explore whether bonds are an interesting investment in the year ahead. To answer this question, we look at the future path of interest rates, the current bond valuations and the credit outlook.

Will interest rates rise much further?
Bond prices are largely impacted by interest rates. When interest rates rise, bond prices go down and vice versa. When inflation rises, central banks raise interest rates to slow down consumer spending and encourage saving. Less borrowings and more savings reduce the money supply which cools down the economy. Many factors impact inflation. One of them is money supply which is illustrated in Graph 2. In 2020, vast amounts of stimulus were announced to support the economy in the aftermath of the pandemic. The money supply grew from below 5% to over 25% year over year. However, since the end of 2021, the money supply growth has returned to normal levels. This should support the desired inflation rate of 2% over the longer run.

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Inflation tends to start with goods inflation which could then be followed by more sticky service inflation. For inflation to cool down, we need to see these sticky components such as wages come down.

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