Amy Xie Patrick: A fixed-income perspective on current market volatility

Pendal’s head of income strategies, AMY XIE PATRICK, explains what the recent market volatility means for fixed-income investors

• Trending ‘unwinds’ contributing to risk-off sentiment
• Volatility expected to stabilise and then fall
• Why bonds, why now? Pendal’s income and fixed interest experts explain
• Browse Pendal’s fixed interest funds

BIG market moves have rocked sentiment since the beginning of August.

The table below shows market moves in equities, credit, volatility and bonds since August 1.

These are classic “risk-off” moves.

Figure 1: Risk off!
Major benchmark moves since market close on Thursday 1 August 2024

Whiplash

For bond investors, it’s not so much the fall in yields that was interesting to witness in the price action of the past few market sessions. It’s the fact they rebounded significantly from the lows seen on Monday, August 5.

US 10-year yields, for example, backed up 19bps from Monday’s session lows and US two-year yields rebounded by more than 30bps.

Perhaps the market remembers the whiplash from early 2024.

Rate markets rushed to over-interpret the Fed’s end to hiking as the start of the next concerted easing cycle. But they were disappointed by an overt “wait-and-see” stance from Fed officials.

In Australia, our markets priced in four rate cuts from the RBA earlier this year, but had to swiftly walk that back when resilient economic and sticky inflation data failed to support those hopes.

Only a few weeks ago, Australian short-end rate markets were pricing in a 50 per cent chance of the August RBA meeting raising the overnight cash rate a further 0.25% to 4.60%.

Following a more benign-than-feared June CPI release, the meeting ended with another hold decision — and an RBA that still “rules nothing in or out”.

Is this an emergency?

In the US, market pricing currently sees a 100% chance of a 0.50% cut in September, followed by consecutive 0.25% cuts in subsequent Federal Open Market Committee meetings.

The argument seems to be that had the Fed seen the full suite of July data at its end-of-July meeting, the central bank would have opted to cut.

On top of this, some big-bank economists are now calling for back-to-back 0.50% cuts – even an inter-meeting emergency cut.

Are things really dire enough to justify a panic to easing?

We argue the data isn’t there yet.

The US labour market report was the main cause of the market’s negative reaction on August 2.

The gain in employment fell well short of market expectations. Unemployment rose from 4.1% to 4.3% while the market anticipated no change.

Employment gains, however, were still gains.

Coupled with a slight fall in average hourly earnings, this is the kind of data that would have had bond and equity markets partying a couple of months ago.

Monday night’s release of a healthier-than-expected set of ISM Services data pointed to no evidence that a recession is waiting on our doorstep.

Similarly, second-quarter earnings season in the US so far shows an earnings beat of 5.2% versus analyst expectations.

This puts total earnings growth from the companies that have reported so far at over 11%.

In recessions, earnings typically fall by 10% or more – so the corporate picture also doesn’t have the US in a recession. Yet.

Various unwinds

A bigger reason for the risk-off market sentiment could be a combination of recent events:

• A “great rotation” away from expensive tech to less expensive small caps, as investors become sceptical that AI-related hype can meet with real results
• The “yen-unwind”, as the Bank of Japan starts to remove the cheapness of yen funding from international carry and risk-seeing trades
• The “great de-grossing”, as risk-parity funds rush to reduce exposures as volatility rises.

By themselves, these trends naturally run out of energy.

The rotation into small caps should end because 40 per cent of Russell 2000 companies are not profitable.

Carry trades should unwind when the excesses in their momentum to the upside have been unwound.

And the risk-shedding of risk-parity funds will end so long as there are not marginally incremental waves of risk-shedding.

Volatility should stabilise, then fall.

Watch the economy

We think fundamentals or a systemic shock are needed to ignite the next recession. Unfortunately, there are a few fundamental developments to worry about.

Over the next year, analyst earnings expectations for the S&P 500 have growth at more than 10% per quarter. That’s not to say it can’t happen — but not even a soft landing seems to be baked in there.

Default rates have continued to climb among US corporates, but even including the moves of the past week, credit spreads are near their cycle lows.

The New York Fed’s recession probability index has climbed to new cycle highs. We know that after a lag, the VIX Index (a gauge of market volatility) also follows.

Vacancy rates in US office real estate have continued to rise and now sit at over 20 per cent. As a result, delinquency rates in US commercial real estate are climbing.

Not just yet

The conclusion of our analysis is that it’s not quite “the big one” just yet.

Following big positive runs in bonds, we need to take a calm breath and ask whether the fundamentals justify the pricing of emergency cuts.

If not, profit-taking comes first. Waiting for the next opportunity to buy bonds comes next.

Zooming out, we’re in the ripe part of the cycle for owning some bonds in portfolios, regardless of your stance on risky assets.

Without a recession, bond yields should continue to fall steadily as central banks around the world normalise their policy settings from restrictive levels.

Some have more work to do than others. Many have already started the journey. That’s because we won’t be talking about inflation as a problem for much longer.

With a recession, bonds will pay for themselves.

Bonds are not guaranteed to perform all the way to the end of a recession, but they’ve always been useful at the start of recessions.

Since the start of recessions are hard to predict, bonds provide great insurance for the unpredictable.

Add to that the 4% types of annual income returns you can currently get on US or Australian 10-year bonds and it basically amounts to being paid to take out insurance.

That’s a nice change from the insurance inflation we’ve all been experiencing for the past two years.