The writer is one of the owners of Meitav Investment House. The article should not be considered a recommendation or a substitute for the reader’s independent judgment, or an invitation to make a purchase or investments and/or any actions or transactions. The information may contain errors and market changes may apply
The government bond markets in the world and in Israel are affected by a very long list of factors. Among these: the current level of inflation in the economy and that which is expected according to forecasters and market players, the monetary policy of the central banks, which can be expansionary, contractionary or neutral, and determines the interest rate accordingly, the fiscal policy of the government which can also be expansionary or contractionary, and accordingly more are issued Or fewer new bonds, and the way the investing public reacts to all of this – with an increased appetite for risk in the channels of shares and corporate bonds or by preferring investment in a “bunker” of government bonds.
Significant geopolitical events also affect the behavior of the government bond markets, since in a period of geopolitical tension the investing public sees the bonds of established countries as a kind of safe haven for bad times.
Since the beginning of the year, nothing fell in the markets, when several factors accumulated that had a multi-directional impact on the markets.
On the one hand, the Russia-Ukraine war broke out, which was supposed to make investors run towards the safe haven, that is to buy government bonds of countries like the USA and Germany, and on the other hand, the same exciting geopolitical event resulted in a significant worsening of inflation, which was manifested mainly, but not only, in energy and in food, and forced the central banks to tighten monetary policy in the direction of accelerating interest rate increases. An accelerated increase in interest rates works in the opposite direction on the bond markets – and has a negative effect, especially when interest rates even after the increases are still lower than inflation rates.
Which was stronger? Of course the interest rate effect, which will always have the biggest impact.
Indeed, at the same time as the declines recorded in the stock markets in the first half of 2022, there were real declines in government bonds as well. Thus, while the S&P500 index fell by 20.5% until the end of June, the 10-year US government bond index And more fell by 21%. And when the American stock market recovered from the declines and made an upward correction, so did the US government bond market.
The government “doesn’t like” rising interest rates
And as for Israel – after many, many years of very low inflation, sometimes zero and in some years even negative, the inflationary “demon” has come out of the bottle and the inflation rate in the last 12 months stands at 5.2%, a rate not seen in our districts since 2002 (6.5%). In both cases the Bank of Israel, which is responsible for the price stability target, which is 1% to 3% per year, reacted late.
In 2002-2003 the bank reacted aggressively and raised the interest rate from 3.5% to 9.1% and managed to stifle inflation to such an extent that in 2003 it was negative at all (minus 1.9%). This time, the interest rate stood at 0.1% for a long time, and in a series of increases it reached 2% and the hand is still tipped, probably in the direction of 3% interest in about six months.
The government bonds “don’t like” rising interest rates, which usually causes their prices to fall, and the longer the average life of the bond (the MOR), the harder the damage to the interest rate. But, we need to put an asterisk here: if the markets are impressed by the determination of the central bank in its interest rate hikes in order to stifle inflation, so at a certain point approaching what the markets think will be the end of the raising process, bond prices stabilize and even rise. That was the case in 2003 and that is likely to be the case this time as well.
In 2002, shekel bonds of the Shahar type for 5 years and more decreased by an average rate of about 20%, and the annual yield to maturity of the longer ones reached almost 12%. Later, in 2003, they rose by no less than 36% – to teach us that there are periods of time when bonds, and not just stocks, behave in a really unstable manner.
Not only the monetary policy, but also the fiscal policy influences the behavior of the government bond markets, but its influence, except for exceptional periods, is much smaller.
The forecast recently provided by the Treasury regarding the path of the expected deficit until 2025 speaks of a zero deficit. This means that the government will need much less funding from the market, in other words, it will not need to borrow from the market to the same extent as it used to do until now.
The bond reform is designed and the convenient options to raise abroad also weaken the need to issue in Israel.
In the US, the government’s measures will put pressure on bond prices
In the US the situation is different in many ways. First, the inflation rate is high compared to Israel, although the gap has started to narrow. Correspondingly, the interest rate is higher – 2.5% in the US compared to 2% in Israel. Third, both the monetary and fiscal policies in the US were until recently much more expansionary and aggressive than in Israel.
The result is that the US government is carrying a huge debt amounting to about 24 trillion dollars, and its debt-to-product ratio has skyrocketed to the level of 98% (only for the federal government), while in Israel, even after it rose to about 70% due to Corona, the ratio is still very low compared to the US.
Moreover, the central bank in the US, beyond the zero interest rate that it introduced for many years, purchased trillions of US government bonds and in this way injected liquidity into the markets.
Now, as part of its contractionary policy, the Fed has decided that not only will it not purchase any more government bonds, but that it will reduce its balance sheet starting in September at the rate of $90 billion a month, or more than a trillion dollars a year. And if that’s not enough, the US government’s borrowing balance, which in recent months has been zero, is expected in the coming months to issue bonds amounting to about $160 billion net, and together the two branches of the government are supposed to absorb about a quarter of a trillion dollars a month from the market.
This, together with continued interest rate hikes, may pressure bond prices down and yields to maturity up.
Behaving similarly, conveying a different message
So far this year, the government bond market has behaved similarly to the stock market, when stocks have fallen, government bond prices have also fallen, and so have gains.
Does this similar behavior, which does not really characterize these two markets, mean that they are sending a similar message? The answer is absolutely no.
Not only is the message not the same or similar, but it is the other way around: stocks fall when investors fear that the economy is headed for a recession and then the firms’ profitability will suffer. But, the same fear of a recession should be the hope of the investors in the government bonds, since the development of recessionary conditions should result in the cessation of interest rate increases, and perhaps even the beginning of a trend of lowering interest rates, and this should serve the interests of the bondholders well and generate capital gains for them.
Furthermore, the shape of the yield curve in the USA, which instead of rising as usual from right to left, falls from left to right, reinforces the notion that its economy is going into recession.
And of course also in the opposite direction – when the stocks rise in anticipation of growth and an increase in the profitability of the firms, the bond owners fear in this case more inflation and more interest rate increases.
Fed Governor Powell, in his speech at the recent Jackson meeting, clarified that the central bank is determined to return inflation to a reasonable level of 2%, and hence more interest rate hikes are expected that will cause “some pain” to the economy.
So whose expectations will turn out to be right – the shareholders’ or the bondholders’? We will wait with eager anticipation.