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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 they are not motivated to cut rates either.
Therefore, long-term rates might rise further as the following factors put upward pressure on yields:
- Central banks are sticking to their ’higher-for-longer‘ mantra. That means that while front-term rates remain anchored, the long part of the yield curve is free to rise.
- The Bank of Japan is looking to exit yield curve control. That means Japanese investors will gradually repatriate as domestic bond yields rise.
- Quantitative tightening (QT). All developed markets central banks are using policies to reduce their huge balance sheets by not reinvesting part of or all redemptions.
- Expectations of central banks to be done with the hiking rate cycle will motivate investors to engage in trades to benefit from the steepening of the yield curve. That means that investors will be looking to buy the front end of the yield curve and sell the long end, putting further pressure on long-term 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.
The moment to increase duration exposure is approaching
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.
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