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.