Approaching end of interest-rate rises bring bonds back in fashion

Both the Federal Reserve and the European Central Bank still have more interest-rate rises in store, but both have signaled that jumbo increases of 75 basis points or more are unlikely to be repeated  (Photo: iStock)
Both the Federal Reserve and the European Central Bank still have more interest-rate rises in store, but both have signaled that jumbo increases of 75 basis points or more are unlikely to be repeated (Photo: iStock)

Summary

Government bonds have started to regain their appeal among investors who are starting to anticipate the prospect of interest-rate rises peaking as recession risks grow

This marks a turn in tide for this asset class after it posted one of its worst period in decades in the first half of the year, sending yields sharply higher as rampant inflation forced central banks to raise interest rates swiftly.

Fast forward a few months and the end of the current cycle of rising interest rates looks in sight, possibly early next year, which should limit any further rises in bond yields.

“There is value starting to show up in the fixed income market," James Penny, chief investment officer at TAM Asset Management, told Dow Jones Newswires.

“I don’t say we have found the bottom, absolutely not, given quantitative tightening, inflation and interest rate rises, but definitely more opportunities are showing up in the bond market than for a long time," he said.

Both the Federal Reserve and the European Central Bank still have more interest-rate rises in store, but both have signaled that jumbo increases of 75 basis points or more are unlikely to be repeated.

“A conclusion of the Fed[eral Reserve] hiking cycle by the January FOMC meeting and moderating inflation, alongside a soft landing for the U.S. economy, drive yields lower, but gradually," Morgan Stanley’s rates strategists write in an outlook for 2023.

“We see 10-year Treasury yields trading around 3.75% by the middle of 2023 and around 3.50% by the end of 2023."

They also predict that 10-year German Bund yields peaked at 2.50% in October.

Markets price the European Central Bank’s peak deposit rate below 3% versus 1.50% currently, and the Federal Reserve’s peak fed-funds rate at around 5% versus the current range of 3.75% to 4%.

“Peak inflation and the turning point for monetary policy are likely to be reached soon, so the potential for further yield rises is limited," Frank Engels, member of Union Investment’s board of managing directors said in an outlook.

The rates market has now largely absorbed the changes in the key economic parameters of growth, inflation and monetary policy, he said.

At the same time, however, yields are back at a level that, unlike in recent years, “make safe-haven bonds appealing to investors."

Having started the year in negative territory, at around -0.12%, the 10-year Bund yield soared above 2.5% in October, before retreating toward 2% in November, according to Tradeweb.

In the same period, the 10-year U.S. Treasury yield has risen to 4.34% in October from 1.54% at the beginning of the year before slipping below 4% in mid-November, according to Tradeweb.

Ten-year U.S. Treasury yields at 4% are probably more attractive than equivalent German Bund yields at 2% and “for us they start to look attractive," Colin Graham, head of multiasset strategies at Robeco, said in a webinar.

Looking toward 2023, investing in U.S. Treasuries at these levels would work well, he said.

What might scupper this forecast would be if there was a soft landing, where the Fed would manage to reduce inflation without causing economic contraction, rather than a harsher recession.

“If we muddle through and there is a soft landing…then the rates will have to go higher and government bond yields have to go higher," he said.

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