Senior Fixed Income Strategist
Summary: The bond market is telling us that inflation will drive monetary policies going forward. We expect 10-year yields to remain rangebound between 1.4% and 1.6% in the US until the debt ceiling crisis has found a resolution. In the UK, Gilts remain vulnerable to inflationary pressures as they enter a fast area, which could take them to 1.2%. The divergence between German Bund yields and the breakeven rates continues to widen, showing that rates have plenty of upside. Investors will find it troubling that US, UK, and European investment-grade corporates aren't not offering a buffer against inflation expectations. At the same time, US and European junk bonds offer a small buffer against inflation expectations of 1.45% and 0.9%, respectively. However, UK junk bonds are offering zero returns in real terms.
We believe that the selloff in the bond market is finally putting things into perspective: inflation will drive monetary policies going forward.
Inflation expectations are rising across the world, driving nominal yields higher. The move can easily be attributed to rising energy prices. However, we have reasons to believe that other elements such as shortages of both components and labour add to the risk of persistent inflation.
Regardless, what is becoming clear is that central banks will need to respond to avoid the economy from overheating. Tight monetary policies impact economic demand, but to what extent can they resolve supply chain disruptions? The answer to this question is complex. Yet, it's intuitive to conclude that interest rates hikes might become necessary as early as this winter. The later central banks will begin to hike interest rates, the more they will fall behind the curve risking even higher inflation.
US Breakeven rates resumed their rise but remain below their May highs.
Therefore it’s likely to see 10-year US Treasury yields trading rangebound between 1.40% and 1.60% until a resolution for the debt-ceiling is found. Indeed, long-term Treasuries will serve as a safe haven as volatility in the money market increases.
In the meantime, 10-year UK breakeven rates spike to 2008 highs, pushing yields to break resistance at 1.07%. Ten-year Gilts are now trading in a fast area, which could take them to 1.2%.
The divergence between ten-year German Breakeven rates and Bunds continue to widen, showing plenty of upside for Bund yields.
Ten-year German breakeven rates rose to the highest level since April 2013. It adds pressure for higher Bund yields, which we expect to turn positive by the end of the year.
Probably, the most troubling factor for Bond investors is that corporate bonds are not offering a buffer against inflation any longer.
Investment-grade bonds in the US, UK and Europe are providing returns below zero in real terms. Although US and European junk bonds provide a tiny buffer against inflation expectations, 1.465% and 0.95%, respectively, UK junk bonds provide near-zero real returns.
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