February 22, 2023

After a decade of near-zero interest — in which consumers and corporations alike enjoyed lenient financing conditions — rates around the world have risen as central banks battle to curb inflation , hammering markets as a result. However, amid signs that inflation is cooling and that interest rate hikes might be slowing, the bond market stands to become a major beneficiary. Global bond markets surged 4.1% to start the year, their best performance since 1999.

As a result of this outperformance, high-quality fixed-income assets are looking increasingly attractive. But the tightening cycle is not over yet; so, is the bond market rebound here to stay?

Companies and governments globally issued nearly $600 billion worth of bonds in January alone. In light of slowing economic growth , markets are betting central banks will pull back on interest rate hikes as recessionary risks mount. This direction is bolstering demand for bonds, which are seen as safe-haven assets.

“The sell-off we saw in late December was precipitated by hawkish moves by central banks. But now, we see a moderation in Fed tightening expectations to start the year,” said Jay Barry, Co-Head of U.S. Rates Strategy at J.P. Morgan. The Fed moved from 75 bp hikes to 50 bp hikes in December 2022 and downshifted further to 25 bp in February 2023. “This is certainly a reason for the recent bond rally, particularly as it is accompanied by a moderation in inflation. With that, investors are more comfortable that we are getting closer to the end of the tightening cycle,” said Barry.

On one hand, investors are seeking to lock in the current high yields before inflation starts to moderate. “Even though yields are declining, they are close to their highest levels in the last 10 to 15 years,” said Barry. This is making recently issued bonds more attractive thanks to their sizeable coupon payments, which offer meaningful returns.

On the other hand, when interest rates fall, bond prices go up and yields (which move inversely to prices) decrease — a boon for investors seeking stable, low-risk assets. In the U.S., Treasury yields have declined on the back of dovish global policy developments, weakening economic data, rising recession risks and strong demand for duration.

Overall, the prospect of slowing interest rate hikes could spell good news for DM bond markets, where further positive returns are projected for 2023. “The broad expectation of a pause over the next few months is fully priced across various DMs,” noted Fabio Bassi, Head of European Rates Strategy at J.P. Morgan. “However, the job on the tightening cycle is not done yet and it is far too early to declare victory in the fight against inflation.”

Despite the recent rally and improved demand/supply balance, J.P. Morgan Research expects bond markets to be more volatile in the near term, with yields trading within a choppy range. This is as markets brace for the next big policy shift from central banks, which are still maintaining a hawkish outlook.

“DM bond markets remain in a tug-of-war between central banks that continue to deliver a broadly hawkish message of ‘tightening cycle not over yet’ while dismissing early expectations of rate cuts, and inflation prints that have started their decline with some downside surprise relative to consensus,” said Bassi. “The decline of inflation on base effect, combined with the large and sharp amount of rate hikes delivered so far, will warrant DM central banks pausing and taking stock of the impact of the tightening on the growth and inflation outlook. But at the same time, DM central banks will be quite reluctant in declaring an early victory against inflation.”

Overall, while demand for credit will remain elevated, particularly given positive year-to-date returns and attractive yields, the scope for a further bond market rally is limited. “The tug-of-war will probably be ongoing, so we expect conditions to be choppier. But as we are close to the end of the tightening cycle and because growth is weakening, we don’t envision yields to revisit the highs we saw last fall,” noted Barry. “Overall, we think we’ll see a range-bound environment persisting, with yields 15 bp to 20 bp lower at the end of the year than they are right now.”