Rising Bond Yields Create Fixed Income Opportunities

In Europe, growing expectations that the European Central Bank will hike rates another 75 basis points in October helped push 10-year Bund yields up 9 basis points to 2.09% on the day, to hit their highest levels since the Eurozone debt crisis in 2011. UK gilts also fell further on concerns over debt sustainability following last week’s budget announcement, 5-year gilt yields rose 48 basis points on Monday to a post-2008 high of 4.52%, after rising 51 basis points on Friday.

Global bonds are now in bearish territory (down -20% from their peak) for the first time in over 70 years.

The rise in yields partly reflects the unraveling over the past month of expectations of an early pivot in central bank policy, and in particular the Federal Reserve. But we think the rise in longer-term yields may not accurately reflect the risks the economy faces:

  • The Fed continues to stress that controlling inflation is its priority…On Monday, Fed officials reiterated the central bank’s hawkish stance. Cleveland Fed Chair Loretta Mester said it costs more to do too little to contain inflation than too much. Atlanta Fed Chairman Raphael Bostic stressed that “the most important thing is that we need to get inflation under control…until that happens, we’re going to see, I think, a lot of volatility on the market in all directions.
  • …and the short end of the yield curve is fully priced for an IPL up cycle. Federal funds futures pricing, which suggests a peak next May at 4.62%, is in line with the FOMC dot chart, which estimates a final federal funds rate of 4.6% in 2023. Two-year Treasury yields at 4.27% have risen 88 basis points since Fed Chairman Jerome Powell’s hawkish speech in Jackson Hole a month ago.
  • But longer-term returns may have gone too far. The magnitude of the recent rise in yields has pushed real yields higher, tightening financial conditions and increasing the risk of the US economy tipping into recession. In our view, 10-year US Treasury yields at 3.84% (Tuesday morning) are likely already near their cycle highs and our year-end forecast is 3.5%. If inflation declines, this will likely lead to lower expectations for Fed policy hikes, supporting bonds. Conversely, if inflation and rate expectations remain elevated, this will likely increase the potential severity of any future recession and increase demand for hedging assets like long-term bonds. We expect 10-year yields to fall to 3.25% by June 2023.

So, after rising global interest rates and credit spreads this year, and with markets already pricing in an aggressive central bank tightening cycle, the risk-reward ratio of fixed-income securities has become more favourable. The best approach, in our view, is for investors to focus on the higher quality (US agency MBS) segments of fixed income securities where absolute rate levels currently provide a significant margin of safety against possible further increases. rate. Starting yields are attractive and are often a good predictor of future returns. Second, opportunities are emerging in the credit sector as spreads widen. We suggest a selective approach where investors focus on issuers that are strong enough to withstand a tougher macroeconomic backdrop.

Main contributors – Mark Haefele, Vincent Heaney, Frederick Mellors, Patricia Lui, Jon Gordon

The content is a product of the Chief Investment Office (CIO).

Original Report – Rising Bond Yields Create Fixed Income Opportunities, September 27, 2022.