Bonds: What to do until inflation stabilises Bonds: What to do until inflation stabilises Bonds: What to do until inflation stabilises

Bonds: What to do until inflation stabilises

Althea Spinozzi

Head of Fixed Income Strategy

Summary:  Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain inflation and evolving monetary policies.

Market liquidity efforts and inflation remain key

In June, the Fed began to ease the pace of their Quantitative Tightening (QT), while the Treasury Department initiated US Treasury buybacks to enhance market liquidity. Despite these efforts, US Treasury yields are expected to remain elevated until inflation trends decisively return towards the 2% target. If the economy cools, support for US Treasuries may increase, but the Fed's reluctance to make significant rate cuts will likely counterbalance this demand. Meanwhile, Europe’s inflation rate has fallen below that of the US, allowing the ECB to potentially adopt less restrictive monetary policies, even though inflation remains above its target. 

This sets the stage for the upcoming quarter, with potentially growing divergence between the US and Europe. Although the interest rate differential between the two regions has widened significantly this year, forward swap markets predict these spreads will converge over the next three years, suggesting that increasingly divergent monetary policies are unlikely.  However, if Eurozone inflation continues to moderate relative to the US, interest rate differentials could return to pre-pandemic levels, leading to steeper yield curves in Europe.

Despite the widely anticipated and well-telegraphed rate cut in June, ECB policymakers appear hesitant to further diverge on monetary policy. They are remaining data-driven rather than committing to a specific rate path for the rest of the year. Consequently, we can expect short-term rates to remain stable, with yield curves steepening slightly as the European economy recovers and PEPP disinvestments begin in July. 

Strong demand to underpin corporate bonds as yields remain attractive

Despite a continuous deterioration in corporate bonds, investment-grade corporate bonds are likely to remain well bid as direction on inflation remains uncertain, and primary markets enter hibernation. As the Fed slows down QT and the ECB begins to cut rates, a further tightening of credit spreads is likely.

Similarly, high-yield corporate bonds are expected to remain underpinned throughout the third quarter. While spreads in the junk bond market are tight compared to historic averages, high-yield bonds have proven to be a crucial hedge against inflation over the past two years. With ongoing uncertainty about central banks' success in combating inflation, high-yield corporate bonds are anticipated to remain supported despite weakening fundamentals. In this environment, cherry-picking and bottom-up analysis become critical.

Investment implications

Performance in rate markets remains closely tied to the path of inflation. As the divergence between the US and Europe continues, it is important to maintain a cautious stance and limit duration exposure. Therefore, we remain positive on quality and maturities up to five years, while remaining cautious on credit risk and longer durations.

Developed markets' front-term rates have peaked in 2023, offering a win-win scenario for bond holders. For example, assuming a one-year holding period, the 2-year US Treasury yield would need to rise above 10.6% to result in a negative return, while the 2-year German Schatz yield would need to rise above 6% to provide a negative return over the same period.

Long-term rates remain vulnerable to the pace of inflation returning to 2% and a possible rebound in the term premium, especially as concerns over the sustainability of deficits grow. If US economic exceptionalism continues, ten-year US Treasury yields might rise to test 5% once again, dragging European sovereign yields higher, too.

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