Asia wrap: Bonds good value?

Last week witnessed a notable and extensive rally across various asset classes, with oil being one of the few exceptions, experiencing a sell-off. Both equities and bonds exhibited movements exceeding two standard deviations, marking one of the most significant weekly rallies in asset classes in the past two decades. Consequently, higher frequency correlations between equities and bonds (measured over two weeks) reverted to positive levels after briefly reaching zero in October.

Since the summer, the trend of "bad news is good news" has resumed for risky assets and duration. With reduced concerns of a recession, negative surprises in growth indicators, such as the weaker ISM and employment data from the previous week, led to a more dovish reevaluation of real interest rates, benefiting equities and bonds.

Bond markets experienced a bull flattening, but the drivers varied by region. In the US, the rally was driven by lower long-dated real rates, supported by a decrease in duration supply, cooling economic data, and a reversal of short-duration positioning.

In Europe, negative inflation surprises contributed to a drop in market-implied inflation, and short-term rates moved more significantly than historical patterns would suggest. Sovereign spreads tightened due to improved risk sentiment and lower core rates. 

In Japan, bonds sold off as the Bank of Japan discontinued fixed-rate purchase operations. The market is already pricing an approximately 9-basis-point hike in the policy rate by the end of Q1-24. However, Japanese economists are coalescing around the idea of the BOJ terminating negative interest rates in October 2024.

Overall, the rally across asset classes last week eased financial conditions by approximately 50 basis points( as per Goldman Sachs models). Consequently, the US Financial Conditions Index has returned to its level at the beginning of the year despite the 100 basis points of rate hikes year-to-date.

As the Federal Reserve acknowledged the recent tightening of financial conditions, this reduces the necessity for future rate hikes, potentially increasing the risk of hawkish surprises and markets needing to reevaluate the possibility of Fed rate cuts early next year.

Although market-implied probabilities for further 10-year OIS rate increases are still elevated (except in Japan), they have decreased along with declining rate volatility. Regarding asset allocation, most observers, weeding the usual bulls and bears, think it is very unclear; augering for neutral into year-end, the expectation is that, with ongoing disinflation, equity-bond correlations will eventually turn less positive, making bonds a better "risk-off" hedge in the event of significant downside growth surprises.