Head of Fixed Income Strategy
Summary: Is a bond bull market ahead? Inflation still poses a risk for investors, but the moment for increasing duration to your portfolio may be approaching towards the end of the year, when central banks might be forced to cut interest rates.
The last quarter of the year will see stagflation deepening on both sides of the Atlantic. The recession that started in Germany and the Netherlands will spread to other European countries, and growth will decelerate significantly in the United States. Yet, inflation will remain elevated throughout the rest of the year and the next, forcing central banks to maintain a hawkish bias.
However, it won't mean we will see more interest rate hikes. The increments of hikes have already become smaller, and some central banks have been pausing hikes at some meetings. That means we are approaching the end of the hiking cycle or that we may be done with hikes already. What will follow is a fine-tuning of monetary policies trying to maintain a hawkish bias as inflation remains above central banks’ targets. The horizon, however, will be clouded with a deceleration of economic activity and geopolitical risk, which will build the case for a bond bull market.
Within this framework, it is safe to expect a steepening of yield curves through the last quarter of the year on both sides of the Atlantic, as markets consider how long rates can be kept at current levels before the cutting cycle begins. While rate cuts are bullish for short- and long-term bonds, the period that precedes it may not be bullish for long-term bonds. That’s what we have seen lately, when developed markets yield curves bear-steepened, with ten-year US Treasury yields hitting 4.36% this August, the highest level since 2007.
The ‘higher-for-longer’ message reverberates when looking at breakeven rates. Despite inflation expectations adjusting lower from their 2022 peak, they have stabilised slightly above the Federal Reserve 2% target. That means the central bank might not have incentives to hike interest rates further, but it is not motivated to cut rates either.
Therefore, long-term rates might rise further as the following factors put upward pressure on yields:
Hence, we might witness a last leg up in interest rates before they collapse as central banks get ready to cut interest rates. That's why we continue to favor short-term sovereigns, while we see scope to increase duration exposure towards the end of the year.
Inflation still poses a significant risk to bond investors. If it rebounds after central banks have reached their peak rates, it may mean more tightening is needed despite a profound recession. Although this decision will most impact the front part of the yield curve, it is important to note that long-term yields will soar too. That happened in the '70s: yields rose across maturities as stagflation aggravated. Yet, much smaller moves in long-term bond yields will produce more significant losses.
Two-year US Treasuries (US91282CHV63) now offer a yield of 5% and have a modified duration of 1.5%, meaning that if the yield suddenly rose by 100bps, an investor would lose only 1.5%. On the other hand, ten-year US Treasuries (US91282CHT18) have a modified duration of 8%.
Therefore, given that the inflation outlook is still uncertain, short-term bonds are ideal to park cash and wait for a better investment environment. At the same time, longer-term sovereigns become appealing once inflation has no chance to rebound.
As the recession deepens, inflation will become less of a concern. Better opportunities to add duration to one's portfolio will emerge towards the end of the year when central banks might be forced to ease the economy.
Inflation linkers present a decade-long opportunity. Two-year US linkers (US912810FR42) are paying 3% in yield. Ten-year US inflation linkers (US91282CHP95) and 5-year US inflation linkers (US91282CGW55) pay slightly above 2%, offering the highest yield since 2008 and creating the tightest conditions since the global financial crisis.
The beauty of inflation-linked bonds is that they have dual exposure to inflation and rates. That means that if inflation rises, their notional and coupon will increase. However, if inflation reverts to its mean, linkers will gain from a drop in interest rates, despite paying smaller coupons and par at maturity.
Inflation is expected to remain elevated this year and the next despite the aggressive hiking cycle undertaken. We have, therefore, arrived at an inflection point where either rates are too high or projected inflation is priced too low in the market. In either case, inflation linkers offer an excellent risk-reward ratio under both scenarios in a well-diversified portfolio.
While real rates at 2% present an opportunity for savers, they threaten borrowers and growth. The only time real rates sustained above the 2% mark was between 2005 and 2007, preceding the global financial crisis. It would be naïve not to expect that real rates at historic high levels would not undermine risky assets today.
As stagflation deepens and central banks keep rates high, companies’ credit fundamentals will deteriorate. Businesses will face higher costs of funding, and the ability to adapt to a higher cost of debt will depend on a company's credit quality.
Right now, the spread between junk and investment grade corporate is at the tight pre-COVID levels, with junk paying on average 270bps over investment grade bonds. Therefore, we expect decompression and the HY-IG spread to widen as defaults rise and interest coverage ratios come under greater pressure.
We remain cautious and prefer quality over junk. Investment-grade corporate bonds are attractive, offering, on average, 5.1% in yield now, around the highest since 2008.
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