Recent yield curve moves show that fixed income no longer rewards simple positioning based on forward guidance but needs judgement too, explains David Roberts, Head of Fixed Income at Nedgroup Investments.
Reading government bond markets is no longer simple. Investors have grown used to central banks doing much of the interpretive work for them, from Mario Draghi’s 2012 pledge to do “whatever it takes” back to the first explicit Federal Reserve rate guidance in the early 2000s. But those days have gone, maybe for ever. Navigating core fixed income now takes genuine skill, judgement and experience of investing through what I would call the ‘old normal’, with the task complicated by policy paths in the US, UK, EU and Japan pulling in different directions rather than moving in sync.
The probability of a 25-basis points rate hike at the next Federal Reserve meeting rose from 54 per cent on 19 August to 90 per cent on 1 September. Markets are now pricing US rates rising from the current target range of 3.5 per cent to 3.75 per cent to 4.27 per cent by June 2027.
At present, markets expect the US, EU and UK central banks to hike around three times over the next year, which is already priced into yield curves. The more interesting question is what happens if expectations change again, a question with no formulaic answer. If the number of expected hikes rises to four or five, bond markets are likely to flatten considerably. Shorter-maturity bonds would probably fall further in price under that scenario, while longer-dated bonds are likely to rally, in both absolute and relative terms.
The long view
The logic for this is simple. Higher rates now, or even the perception that rates are heading higher, chokes off growth and inflation over time. That makes longer-dated bonds more valuable to investors looking through the cycle. It is classic curve flattening.
Western markets have tended to see flat to inverted curves whenever monetary policy is tightened, particularly when it is tightened aggressively in response to a single event, such as a supply side energy shock that central banks cannot realistically hope to control by trying to restrict consumption. Aggressive hiking into that kind of shock tends to borrow growth from later years rather than solve the immediate problem, and bond markets usually start pricing that trade-off well before it shows up in the economic data.
In a scenario of four or five hikes, bond investors would likely begin pricing in recession risk for 2028, along with the prospect of sharp rate cuts to follow. That combination – tighter policy now and a weaker growth outlook later – is an environment in which long duration tends to outperform short duration by a wide margin.
We continue to hold a bias towards 30-year bonds in the UK and Japan on the back of this thinking, having closed out a position in the US after a rapid and supportive move in price. We are ready to reverse that US trade should pricing move back in our favour.
The UK gilt curve illustrates the opportunity. It remains notably steep out to around 25 years, with one-year gilts yielding close to 4.25 per cent against around 6 per cent at the 25-year point. That is a decent pick up based on recent experience, and it points to value further out on the curve for investors willing to look past where policy rates sit today towards where the cycle is likely to take them over the next two to three years. Japan offers a similar dynamic, with one-year government bond yields at around 1.5 per cent versus around 4.5 per cent for 30-year bonds.
Neither the UK nor Japan has yet reached the point where the growth trade-off becomes acute, which is why the long end still looks cheap relative to where a flattening cycle would take it. The UK curve in particular has not yet priced in the kind of aggressive front-loaded tightening needed to bring inflation down quickly if the current energy shock proves more persistent than expected, leaving scope for long gilts to outperform further if central banks become more hawkish.
Beware overreacting central banks
Markets have a habit of extrapolating the recent past and assuming that today’s inflation pressure is evidence of a structural problem rather than a temporary supply shock working its way through the system.
An energy price spike, however sharp, does not automatically mean a sustained inflation problem. Central banks that respond as though it does risk over-tightening into a slowdown they did not need to create. That is a dynamic worth watching over the next few months. It is also why positioning by forward guidance alone is no longer sufficient. Reading the signs correctly will take judgement rather than a formula – bond managers now have to think for themselves rather than take their cue from central banks.
