Higher interest rates may be reaching their peak. Steve Ryder and Daniel Bright from our sovereign debt team analyse what this means for the real economy and government bonds globally.
Read this article to understand:
- Why the monetary policy tightening cycle may be reaching its peak
- The impact of a possible soft or hard landing on bond markets
- The risks and opportunities in global sovereign bonds
With yields surging over the last 12 months, bond investors are finding themselves adjusting to the end of a ten-year low-inflation, low-volatility regime.
The return of inflation following fiscal and monetary stimulus amid global supply chain constraints has prompted a rapid tightening in monetary policy and macroeconomic uncertainty. These factors have put an end to the suppression of risk premia and yields, allowing bonds to offer income for the first time in years. But it also means investors can no longer buy bonds indiscriminately in the knowledge they will be supported by central banks’ bond-purchase programmes.
Fundamentals – inflation, deficits, debt levels and even climate change – have regained their place as key drivers of government-bond markets. This is likely to create opportunities for active investors but also – as shown by the recent turmoil in the banking sector, bouts of volatility.
In this Q&A, Steve Ryder (SR), senior portfolio manager, and Daniel Bright (DB), junior portfolio manager, analyse what the new regime means for sovereign-bond markets.
How have recent events shaped your outlook on government bonds?
SR: In January, our central scenario was that central banks’ tightening cycle would end in the second or third quarter. This was due to the record pace of tightening already delivered over the last 12 months and the level interest rates would have reached by then. As policy actions work with a lag, that is also when we expected them to start impacting the real economy. Within that backdrop, we expected growth to moderate and inflation to continue to fall throughout 2023.
Strong data in February caused markets to expect even more central bank tightening
But strong data in February caused markets to expect even more central bank tightening. This was why the sudden failure of Silicon Valley Bank had such a significant impact on the sovereign bond market, brutally shifting policy expectations to concerns of a systemic banking crisis.
While those concerns have eased thanks to swift government action, uncertainty remains as to how the shock to the US banking system will impact lending conditions, which had already tightened significantly before the collapse of SVB.
Overall, the episode has reaffirmed our central scenario the US will end its tightening cycle in the middle of the year as the lagged effects of policy tightening become more visible. We believe this will make shorter-dated bonds more attractive as the risk of further tightening is reduced. In this scenario, we expect shorter-dated bonds to outperform (yields lower) longer-dated bonds, causing the yield curve to steepen.
How are current conditions impacting term premia and portfolios?1,2
SR: Last year’s bond curve inversion was driven by central banks’ committed and aggressive tightening in the face of high inflation. Central banks are still discovering what terminal rates are needed for this cycle, but the pace and level of rate rises means they are no longer playing catch up. The lack of further aggressive tightening should start to reduce the compression of bond term premia.
Following peak policy rates, we expect central banks’ outlooks to be more balanced
Following peak policy rates, we expect central banks’ outlooks to be more balanced. The recent US banking saga has also triggered a trade-off between price stability and financial stability, which will become an increasing focus for policymakers. There remains a great deal of uncertainty as to whether tighter lending conditions will be sufficient to cause a slowdown that will get inflation back to target, but we believe policymakers will be more data-dependent on a meeting-to-meeting basis. If inflation proves sticky and central banks are more cautious, we would expect a rebuilding of term premia as greater uncertainty should command a higher risk premium in longer-dated bonds (see Figure 1).
Figure 1: USD term premium estimates
Source: Aviva Investors, Bloomberg, Deutsche Bank, Macrobond. Data as of April 28, 2023
DB: With curves still heavily inverted, the implied term premium remains low by historical standards. This reflects investors’ expectations the Fed will be able to suppress demand and inflation sufficiently. But we are unlikely to go back to a world where inflation is not meaningful. All else being equal, that should lead to steeper curves as investors should factor in an inflation risk premium.
Many investors took refuge in inflation-linked bonds last year, only to see them lose value in recent months. What happened?
SR: There were huge inflows into inflation-linked bond exchange-traded funds (ETFs) from investors looking for an inflation hedge. However, when you buy an inflation-linked bond, you still have exposure to duration risk. Over 2022, the duration moves far outweighed the inflation-linked pay-out because of central banks’ tightening. In other words, real rate rises drove the price of these bonds down by more than the inflation-linked pay-outs rose.
DB: If you had the view at the start of 2022 inflation was going to go through the roof and wanted protection, buying a ten-year UK inflation-linked bond and holding it to maturity would have guaranteed you a real return. But that was expected to be minus three per cent, just as central banks were about to raise interest rates (see Figure 2, where the real yield on January 3, 2022 was -2.8 per cent).
Figure 2: UK inflation-linked bond real yield and inflation breakeven rate
Source: Aviva Investors, Bloomberg, Macrobond. Data as of April 28, 2023
SR: One area where we have implemented an inflation position is being short, long-dated European inflation because, while inflation has continued to move higher in the euro zone, we expect it to fall in the second half of 2023. In addition, the European Central Bank remains credible and clear on its commitment to bring inflation back to target. That should reduce inflation risk.
In other markets, inflation moved a lot lower during the recent US banking episode
In other markets, inflation moved a lot lower during the recent US banking episode, so some would argue there may be value in buying inflation protection. The issue is, when risk assets fall and bond markets rally, inflation-linked bonds usually underperform nominal bonds. In an environment where there are still concerns around recession, that makes buying inflation-linked bonds a more difficult decision.
Where do you anticipate interest rates going?
SR: Our base case for peak policy rates means we see a limit to the upside for interest rates. The most likely path following the peak is one where most major central banks put rates on hold for an extended period. A pause doesn’t necessarily mean cuts will follow, as demonstrated by the Reserve Bank of Australia, which paused its tightening cycle before surprising the market by raising rates again at the start of May.
While cuts in the second half look premature given our inflation forecasts, the market will likely continue to price them given the uncertainty around US banks and broader concerns around a global slowdown. We expect central banks to begin cutting interest rates in most countries in 2024 as inflation continues to fall and policy no longer needs to be as restrictive to maintain a stable economic outlook.
What does this mean for duration?
SR: With policy rates likely peaking in the next few months across most G10 countries and inflation continuing to moderate, volatility and uncertainty over central bank tightening cycles will reduce and the focus will shift to economic data. This is a supportive backdrop for government bonds, which now offer an attractive income, are once again showing a negative correlation to equities and have generally been under-owned in recent years.
We believe the asset class is now attractive whether we see a soft or hard economic landing
Overall, we believe the asset class is now attractive whether we see a soft or hard economic landing. Both scenarios are supportive thanks to the income available, while a hard landing would provide more capital appreciation as investors would allocate to the safe haven of government bonds and central banks start to ease policy.
What is the impact of already high levels of debt-to-GDP in developed markets, given new commitments around the climate transition and defence?
DB: A key reason we have inflation now is the massive monetary and fiscal stimulus delivered at the start of COVID-19. Given deficits are likely to be maintained through climate change and defence expenditure, it probably means higher growth, all else being equal. It also means a lot more issuance. This is visible in UK and European markets, where the growth in government bond supply – net of quantitative easing purchases – is expected to be large (see Figure 3).
Figure 3: UK gilt issuance since 1999-2000 (per cent of GDP)
Source: Office for Budget Responsibility, March 20232
Overall, we would expect higher issuance to lead to elevated yields and steeper yield curves.
High inflation is good for heavily indebted countries because it translates to high nominal GDP growth
On the flipside, high inflation is good for heavily indebted countries because it translates to high nominal GDP growth, allowing countries to deflate their debt pile. We saw this in 2022 with Italian bonds; rising interest rates could have led to Italian debt becoming unsustainable, but the country’s high nominal GDP growth kept the debt-to-GDP ratio manageable.
SR: When we assess the climate transition, a lot of what we think about within sovereign bond markets is the cost of the transition to net zero and how that will be funded. We expect the bulk to be via conventional government bond issuance, but also an increasing amount through sovereign green bonds, especially with investor demand for green bonds increasing.
Where do you see key risks and opportunities?
SR: One area we are focusing on is the winners and losers of the unprecedented tightening cycle of the last year. We see interest-rate sensitive countries with high household debt as the most impacted, so we are looking at housing markets and countries where loans and mortgages are being refinanced. Those countries include the UK, Canada, Australia, New Zealand and Sweden. We are overweight the UK and New Zealand, as we believe the income and potential for capital appreciation combined offer adequate compensation for the risk.
DB: For different reasons, we are underweight Japanese bonds. After COVID-19 stimulus and global inflation pressures, we think there is a reasonable chance this may be Japan’s opportunity to escape its struggle with deflation. As such, the Bank of Japan (BoJ) is expected to further adjust or remove its yield-curve control (YCC) policy this year.4
Even if the BoJ gets rid of YCC, it will likely be some time before it removes its negative interest rate policy
The shift will probably be slow, however, as any policy changes will be cautious and incremental. Even if the BoJ gets rid of YCC, it will likely be some time before it removes its negative interest rate policy.
Nevertheless, a change in the BoJ’s approach should increase the term premium for global markets, if not lift yields globally. Repatriation of foreign assets by Japanese investors means the yen should appreciate and Japanese bond yields should rise if inflation is sustained, although that will be tempered by domestic inflows supporting Japanese bonds.
SR: We are also considering opportunities in selective investment-grade emerging markets (EM), as there is an EM risk premium to consider and because many EMs hiked sooner than developed markets. As inflation falls, real rates will look attractive. If our view on the US tightening cycle ending is correct, this would be supportive for EM central banks to start easing policy.