Quarterly Outlook
Macro outlook: Trump 2.0: Can the US have its cake and eat it, too?
John J. Hardy
Chief Macro Strategist
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Bond Market Update. UK Election Uncertainty and Yield Curve Dynamics: Why Short-Term Bonds Are the Better Bet
Althea Spinozzi
Head of Fixed Income Strategy
Summary:
- The spread between 10-year and 2-year Gilt yields turned positive for the first time since May 2023, driven by falling 2-year yields and rising 10-year yields.
- Market participants expect a potential Bank of England rate cut by September, but increased fiscal spending under a potential Keir Starmer government could pressure long-term yields.
- Short-term bonds appear to be a more attractive investment due to their lower risk and favorable yield compared to long-term Gilts.
On Monday, the spread between 10-year and 2-year Gilt yields turned positive for the first time since May 2023. While the disinversion of the yield curve was widely anticipated by markets, the timing is particularly notable as market participants prepare for the UK elections on Thursday.
The marked disinversion was driven by a significant drop in 2-year yields, which fell more than three basis points since Friday to 4.16%, alongside a rise in 10-year yields by six basis points to 4.45%.
This divergence between the two maturities indicates that, in the short term, market participants see a 50% chance of a Bank of England rate cut as early as August and expect a full 25 basis point rate cut by September. In the long term, the possibility of a Keir Starmer victory implies substantial investments to achieve an economic growth target of 2.5%. Robust growth prospects suggest that interest rates are unlikely to be aggressively cut, which could exert pressure on long-term Gilts. Furthermore, increased fiscal spending might lead to inflationary pressures, further affecting long-term Gilts.
Short-Term Bonds Offer Superior Risk-Reward Amid Uncertain Economic Landscape.
This outlook reinforces our belief that short-term bonds are a better choice over their long-term counterparts. Currently, 2-year yields offer a yield of 4.13%, which is 12 basis points below 10-year Gilts and 62 basis points below 30-year Gilts. Yet, 2-year yields provide a win-win solution, as the yield on this tenor would need to rise above 11.68% to incur a loss assuming a one-year holding period. Such a dramatic increase in yields would only be possible if the Bank of England initiated another interest rate cycle, hiking rates by more than 600 basis points. Even if inflation remains persistent or increases due to substantial government investments aimed at boosting the economy, it is unlikely that rates will be hiked by such an extent within a year.
In contrast, the risk-reward profile for longer-dated Gilts is less favorable. Assuming a one-year holding period, the breakeven yield for 10-year and 30-year Gilts is 4.9% and 5%, respectively. In the event of a Starmer victory and increased fiscal spending, these yield levels could be easily reached, making longer-term bonds a riskier investment.
Other recent Fixed Income articles:
28-June Bond Market Update: Market Awaits First Round of French Election Voting.
26-JuneBond Market Update: Canada and Australia Inflation Data Dampen Disinflation Hopes.
30-May ECB preview: One alone is like none at all.
28-May Insights into this week's US Treasury auctions: 2-, 5-, and 7-year tenors overview.
22-May UK April’s Consumer Prices: Markets Abandon Hopes for a Linear Disinflation Path.
17-May Strong trade-weighted EUR gives ECB green light to cut rates, but bond bull rally unlikely
14-May UK labor data and Huw Pill's comments are not enough for a bond bull rally
08-May Bank of England preview: Rate cuts in mind, but patience required.
06-May Insights into this week's US Treasury refunding: 3-, 10-, and 30-year overview
02-May FOMC Meeting Takeaways: Why Inflation Risk Might Come to Bite the Fed
30-Apr FOMC preview: challenging the March dot plot.
29-Apr Bond Markets: the week ahead
25-Apr A tactical guide to the upcoming quarterly refunding announcement for bond and stock markets
22-Apr Analyzing market impacts: insights into the upcoming 5-year and 7-year US Treasury auctions.
18-Apr Italian BTPs are more attractive than German Schatz in today's macroeconomic context
16-Apr QT Tapering Looms Despite Macroeconomic Conditions: Fear of Liquidity Squeeze Drives Policy
08-Apr ECB preview: data-driven until June, Fed-dependent thereafter.
03-Apr Fixed income: Keep calm, seize the moment.
21-Mar FOMC bond takeaway: beware of ultra-long duration.
18-Mar Bank of England Preview: slight dovish shift in the MPC amid disinflationary trends.
18-Mar FOMC Preview: dot plot and quantitative tightening in focus.
12-Mar US Treasury auctions on the back of the US CPI might offer critical insights to investors.
07-Mar The Debt Management Office's Gilts Sales Matter More Than The Spring Budget.
05-Mar "Quantitative Tightening" or "Operation Twist" is coming up. What are the implications for bonds?
01-Mar The bond weekly wrap: slower than expected disinflation creates a floor for bond yields.
29-Feb ECB preview: European sovereign bond yields are likely to remain rangebound until the first rate cut.
27-Feb Defense bonds: risks and opportunities amid an uncertain geopolitical and macroeconomic environment.
23-Feb Two-year US Treasury notes offer an appealing entry point.
21-Feb Four reasons why the ECB keeps calm and cuts later.
14 Feb Higher CPI shows that rates volatility will remain elevated.
12 Feb Ultra-long sovereign issuance draws buy-the-dip demand but stakes are high.
06 Feb Technical Update - US 10-year Treasury yields resuming uptrend? US Treasury and Euro Bund futures testing key supports
05 Feb The upcoming 30-year US Treasury auction might rattle markets
30 Jan BOE preview: BoE hold unlikely to last as inflation plummets
29 Jan FOMC preview: the Fed might be on hold, but easing is inevitable.
26 Jan The ECB holds rates: is the bond rally sustainable?
18 Jan The most infamous bond trade: the Austria century bond.
16 Jan European sovereigns: inflation, stagnation and the bumpy road to rate cuts in 2024.
10 Jan US Treasuries: where do we go from here?
09 Jan Quarterly Outlook: bonds on everybody’s lips.
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