The dominant trend in the international bond markets for 2022 is the prospect of gradually tightening monetary policy. Tighter policy is being signaled by the Bank of Canada (BOC) and the Federal Reserve over the next year, while the Bank of England (BOE) surprised markets with a rate hike on December 16, 2021. Emerging-market (EM) central banks are even farther ahead. Leading the way, Brazil and Russia started hiking rates in the spring of 2021. This shift toward tighter global monetary policy is a key reason why global rates moved up and yield curves steepened in many countries in 2021.
Yield curves should flatten in 2022 as policy rates rise. Flatter yield curves could be a plus for returns, but lingering inflation and the slowdown in China are risks that will likely outweigh this. This isn’t the best news for the international bond markets, but it may set up opportunities down the road, and as such we maintain a neutral outlook.
Developed-market bond outlook
Developed-market (DM) yields are on track to end 2021 higher as the economic outlook improved, inflation spiked, and central banks signaled rate hikes for 2022. Given that duration (a measurement of the variation in a bond’s price with changes in interest rates) sits at a high 8.3 years, it should come as no surprise that the Bloomberg Global Aggregate (x-USD) Bond Index is down 6.6% year to date.
Global bonds lost ground in 2021
We expect 2022 could be another challenging year for developed-market bonds. Global bond yields are generally lower than those offered in the U.S., and a strong dollar pulls returns even lower. Those looking for income are unlikely to find it in global bonds, but consider maintaining exposure for the diversification benefits.
When looking at global bonds, the Eurozone and Japan are crucial to watch because they account for 60% of the Bloomberg Global Aggregate (x-USD) Bond Index—the Eurozone makes up 37% and Japan makes up 23%. Both central banks are expected to keep rates on hold over the next year. This means that inflation and growth expectations will have to do much of the heavy lifting to push their bond yields to levels that are more attractive than Treasuries. In today’s environment, this is a tall order to fill. Currently, the yield advantage of the Bloomberg U.S. Aggregate Bond Index over the Bloomberg Global Aggregate (x-USD) Bond Index is near 1%.
The yield advantage in U.S. bonds over global bonds has trended up recently
While the current outlook suggests continued outperformance by the U.S. bond market, we are watching for a change in fundamentals as an opportunity for global bonds potentially to become more attractive. One of those fundamentals is a change in the direction of the dollar. The tables could turn if the dollar weakens in 2022. Over the long run, the large U.S. current account deficit should pull the dollar lower. The current account deficit measures the amount that U.S. imports exceed exports in trade with the rest of the world. The deficit typically leads the dollar by two years, which suggests that by mid-2022 some weakness could emerge, especially if growth outside the U.S. picks up.