Geopolitical tensions fail to stall the rise in long-term rates

Last week's evidence is clear: nobody wants to increase their portfolio's duration as the Treasury sells large amounts of Treasuries, and inflation remains elevated. That concept is likely to be emphasized again this week at the 20-year US Treasury auction, a tenor typically disliked by markets.

Therefore, long-term yields should continue to rise, with the 10-year yields breaking above 5% and possibly rising to 5.25%. Consequently, we remain defensive and favor the short-term maturities, as the yield curve is poised to continue to bear-steepen. Still, front-term yields remain anchored as the Federal Reserve is supposed to have reached the peak of the hiking cycle, but it will stay on hold for longer.

The Gilt yield curve is poised to bear-steepen.

In the UK, wages and inflation are slowing but remain uncomfortably high. While we may be close to the end of the Bank of England's tightening cycle, we are definitively not facing the economic conditions for the central bank to begin easing financial conditions. Therefore, we might face a similar problem to the US, where the higher-for-longer theme will continue to push long-term yields.

Not only that, but Gilts remain correlated to US Treasuries, which yields, as we have explained above, remain on the rise. If you would like to learn more about why we expect Gilt yields to continue to rise, please refer to this link.

We, therefore, continue to favor the front part of the yield curve and quality in the UK.

Short-term bonds offer a win-win scenario.

We favor the front part of the yield curve because the macroeconomic backdrop remains relatively uncertain. An escalation of the war between Israel and Hamas and a possible involvement of the US in the area might mean more spending, hence more bond issuance on top of the already increasing bond supply due to a large ongoing fiscal deficit. That would continue to pressure US Treasuries unless the Federal Reserve steps back from its tightening stance.

At the same time, war increases the chance for inflation to rebound. Hence, the tail event, which sees inflation rebounding in the next few months, might become a reality. In that case, central banks might need to hike rates a few more times. Short-term bonds will prove resilient within that tail scenario, while duration will pose the most significant risks to investors' portfolios.

Yet, it's impossible not to look at the safe havens with interest. If this is the last stretch higher for rates, they might already provide an interesting risk-reward scenario. Indeed, if yields rise another 50bps, German Bunds, US Treasuries, and Gilts would still be in the green. That's different for ultra-long maturities, where the direction of monetary policies needs to become more benevolent for these positions to perform.