Investor Sentiment: US Bond Demand Remains Strong

This data captures behavioral trends across tens of thousands of portfolios and is estimated to capture just over 10% of outstanding fixed income securities globally.

With expectations for continued disinflation, slower growth, and an interest rate easing cycle across most developed market countries, 2024 was billed as the year of more favorable fixed income returns. But — surprise — just as it did in 2023, robust US economic data at the beginning of the year spoiled the party.

Even if there’s a hint of residual seasonality to some of the data, there is little doubt that both US growth and inflation have delivered upside surprises so far in 2024.

The response from institutional investors has been even more surprising. They’ve stuck doggedly to Treasurys and US corporate debt and have lowered, not increased, their allocations to Treasury Inflation-Protected Securities (TIPS). In an environment where overall allocations to fixed income have fallen to 15-year lows, demand for Treasurys and US bonds remains exceptional.

The same cannot be said of global sectors. Inflows into European sovereign debt, especially in the UK and France, have softened — despite what looks to be a more bond-friendly macro backdrop of disinflation and recession. Meanwhile, demand for emerging market (EM) sovereign debt has stalled abruptly as investors reassess the rate cutting cycle in the face of inflation’s recent acceleration.

Allocations at Extremes

Long-term investors’ aggregate allocation to fixed income, relative to equities, has not been this unbalanced since before the global financial crisis (GFC). Some of this relates to price effects; the recent dramatic outperformance of equities has pushed equity allocations within a whisker of a 15-year high. Fixed income holdings have gone in the opposite direction and are now, in aggregate, at their lowest level since the GFC (Figure 2).

Residual allocations to cash are now within 3-tenths of their long-term average, after having been above average for most of 2023. This is important as it implies less dry powder to return to the equity or fixed income markets, unless investors decide to underweight cash.

With equity holdings already so high, especially relative to fixed income, it seems reasonable to assume that only a major boost to the equity outlook could prevent some level of rebalancing back to fixed income. In Q2 it’s likely we’ll learn whether the start of the broader developed market easing cycle is the catalyst fixed income markets have been waiting for, or if it proves to be another false dawn.

Inflation Protection Shunned

There were two surprises in Q1 Treasury demand. First, institutional Treasury demand remained solid in spite of higher yields. That alone shouldn’t be too surprising, given the resilience of demand throughout last year. But the longer demand persists in the face of volatile price action, the more impressive it gets. Institutional demand for Treasurys remains remarkably resilient.

More of a surprise was the weak demand for TIPS in Q1. Given firmer US inflation readings across the quarter and residual, albeit diminished, hopes of rate cuts, one might have assumed that demand for long-term inflation protection would have risen. But the opposite happened. Demand for TIPS fell to the lowest in more than three years in March — suggesting that long-term investors remain untroubled by 2024’s inflation trend, at least for now.

Yield Demand Still Mixed

While institutional investor demand for Treasurys remained strong in Q1, demand for European sovereign debt began to slip, most notably in the UK and France. This suggests that robust institutional demand cannot be taken for granted.

The growing selectivity for sovereign bonds extends to higher yielding instruments. As the year began, demand for both local currency EM sovereign debt and US high yield was increasing. But inflows into emerging markets turned abruptly in February and March. Investors are seemingly more comfortable betting against a US recession than on further accommodations from EM central banks, which is understandable given recent economic news. Meanwhile, demand for European corporate debt has weakened sharply as recession bites in parts of the eurozone have put credit under pressure.