The Bond Backdrop Now

Long rates are up again, nearing the high end of their recent range, spurring warnings of a bond bonfire globally. The alleged culprit: Reheating inflation tied to oil prices, which is prompting markets to price in central bank rate hikes across the developed world. It sounds simple and logical when you pair it with market-based indicators registering higher likelihoods of rate hikes. But we don’t think it holds up. Not only is there scant evidence resurgent inflation is at hand, but bonds’ fitness for a long-term portfolio doesn’t depend on central bankers’ whims.

Whenever bonds hit tough sledding, we see articles claiming they can’t fulfill their mission. Usually, in this context, the mission is cushioning against a stock market decline. While stocks are up now, headlines warn the party won’t last once AI comes crashing down and high valuations implode—and that bonds won’t be able to pick up the slack as they wrestle with inflation and central banks. But we think this is refighting the last war from 2022—and misreads bonds’ purpose and actual recent performance. 

The Chief Role

Bonds’ primary portfolio role is something we see headlines get wrong chronically. It isn’t to be portfolio insurance. Nor is it to generate income, though interest payments can help. We think bonds are best cast as a way to lower a portfolio’s overall expected short-term volatility. While this comes with lower long-term returns, we think the tradeoff can be beneficial for folks with higher cash flow needs and/or shorter time horizons, both of which benefit from a smoother ride.

Note: This doesn’t mean bonds are always less volatile than stocks, and it doesn’t mean they never decline. Nor does it mean they move opposite stocks at all times. Rather, it means their swings tend to be smaller, overall and on average, which helps make cash flow more stable.

In this context, bonds can still do their job even when they decline. While they did fall alongside stocks during 2022’s shallow bear market, they fell less—cold comfort, we know, but still an example of a milder swing.^[i] That era, for bonds, was also a painful side effect of weaning off the artificially low interest rates of the 2010s and COVID era, which resulted from years of central bank bond buying. There was always going to be an adjustment, but markets lived it, took their medicine and moved on.

While yields are up this year, which knocks bond prices, returns actually aren’t awful. As with stocks, it is crucial to focus on bonds’ total return—price movement plus interest. Year to date, US 10-year Treasury yields are up from 4.18% to 4.72%.^[ii] Yet bond returns are just slightly negative. The ICE BofA Corporate & Government 7 – 10 Year Index (a gauge of investment grade, intermediate-term bonds) is down just -0.7% year to date.^[iii] Simply, prices are down, but the interest payments helped buffer them, delivering that smoother ride. This is not a 2022 repeat—it is kinda standard bond behavior.

If hot inflation were about to rear its ugly head, ditching bonds wouldn’t be the answer. Rather, in a diversified bond portfolio, there are things you can do to manage around inflation, like adjust your duration. Longer-term bonds tend to be more interest rate sensitive, so if you have a sound basis to believe rates are likely to rise over the foreseeable future, you can mitigate the effects by moving more into shorter-term bonds. But it is important that this be a carefully considered, forward-looking decision—not a reaction to headlines or recent volatility.

The Current Backdrop

That said, we don’t think repositioning for hotter inflation and higher rates would serve investors well right now. Bond markets, like stocks, pre-price widely expected events and discount all widely known information. All the inflation chatter you read about? It is baked into prices. So are those rate hike expectations. Thus, we think it is more useful to consider what these headlines might be ignoring.

Today, we think they are ignoring the host of benign leading inflation indicators. Start with money supply, since inflation is always and everywhere a monetary phenomenon of too much money chasing too few goods and services. On a GDP-weighted basis, global money supply growth is running at about 5.7%, about one-third of its 2021 high (which preceded 2022’s inflation nightmare).^[iv]

The current growth rate trails rates throughout the 2000s and 2010s, an overall low-inflation era. As for the “too few goods and services” side of the equation, this also looks fine. The Global Supply Chain Pressure Index, which spiked in 2021 and 2022, did tick up this year as war clogged the Strait of Hormuz. But it seemingly peaked in April and eased for the third straight month in July. Here, too, its year-to-date high was far below COVID-era spikes. Market-based indicators like breakeven inflation rates are also benign, signaling markets see little inflation eroding bond payments’ value over the next several years. None of this means central banks won’t hike anyway, but these indicators point to the temptation to do so fading and make the case for hikes weaker and weaker.

Accordingly, we recommend seeing this year’s bond wiggles for what they are: short-term volatility, which bonds have never been immune to. They can and do swing on sentiment, just like stocks. They simply tend to swing less, with milder moves up and down, which is what can make them attractive and important in portfolios for those needing dampened volatility. These wiggles tend to even out, rewarding those who stay disciplined.