investment insights
A peak in policy rates supports bond preferences
Key takeaways
- Interest rates in developed markets are close to peaking, or have peaked. Current high yields make bond markets, in particular sovereign debt, appealing for buy-and-hold and income-seeking investors
- Some near-term risks remain, with high policy rates raising concerns around the sustainability of US public debt
- For investors who may be concerned about inflationary surprises and fiscal sustainability, lowering interest sensitivity and using instruments to shield from inflation risks may be useful
- We retain our preference for developed market sovereign bonds as core portfolio holdings. We have recently raised exposures to emerging market bonds in hard currency, with a preference for corporate credit.
High sovereign bond yields make fixed income attractive for buy-and-hold, and income-oriented investors. With current yields well above their historic averages, government bonds now offer higher expected returns. This was a key consideration in our decision to raise exposures to fixed income assets in our strategic asset allocation late last year.
Fixed income returns are in part driven by interest rate expectations, relative to current market pricing. Since interest rate policy plays a key role in determining the level and shape of the entire interest rate curve, it is important to assess the future policy rate path, and scenario estimates.
Policy rates across developed markets, excluding Japan, have peaked, we believe. Both the Swiss National Bank and the Swedish Riksbank have started cutting rates, and a broad disinflationary trend is in place. We think the European Central Bank (ECB), Bank of England (BoE), and the Federal Reserve (Fed) will each soon start easing monetary policy as well, taking their policy rates to 2.75%, 4.25%, and 4.50% respectively, within the next 12 months. With markets pricing only two Fed rate cuts over the next year, total excess return from a Bloomberg US Treasury index, compared with three-month deposit rates - as a proxy for cash - should be between 4% and 5%.
Inflation: down but not out?
In the eurozone, the path towards disinflation seems well established. In the UK, while April’s inflation declined, its resilience surprised markets, delaying our expectation for a first BoE rate cut from June to August. In contrast, the US has experienced stickier inflation over a number of months this year. This has prompted some repricing of expected policy cuts at the short, or near-term, end of the yield curve, as some investors expect rates to stay higher for longer.
While we acknowledge that there is a risk that the Fed may delay rate cuts, recently weaker US activity data and slowing wage growth still point to policy normalisation ahead. In a risk scenario of no rate cuts in 2024, we would expect US Treasuries to only slightly underperform cash. However, recent US activity weakness also raises the possibility of a faster economic slowdown, in which case inflation worries would subside faster, and Treasuries perform better. In the near term, we currently see both risks as broadly balanced.
What about US fiscal risks?
As investors look ahead to November’s US presidential election, concerns about the sustainability of the US fiscal deficit and future tax policies are rising. Since 2020 and the start of the pandemic, the US deficit has averaged more than 9% of gross domestic product (GDP). With the US debt-to-GDP ratio likely to rise further in the coming years, today’s high interest rate environment makes the task of reducing the deficit challenging. The Congressional Budget Office projects that the interest rate cost to servicing US public debt will account for two-thirds of the deficit over the next 20 years, compared with one-third of costs in the two decades preceding Covid.
Neither US presidential candidate seems willing to let 2017’s income tax cuts expire in 2025. The Biden administration’s agenda looks more likely to focus on higher taxes for the wealthier households and corporates to address the fiscal deficit. Such tax plans would need a Democrat majority in Congress, which is far from clear at this stage. The Republican fiscal agenda may be more challenging because of its potential impact on inflation. Former president and candidate Donald Trump not only seems unwilling to let his previous administration’s tax cuts expire, but would likely propose additional corporate tax reductions, financed by higher import tariffs. While it is unclear whether that would add to the existing deficit, it would likely increase the price of imported goods and fuel inflation, and potentially complicate the Fed’s job of normalising monetary policy while worsening debt servicing costs. In turn, higher interest rate volatility could require higher bond risk premia. Given our current stance on fixed income, these risks warrant close monitoring. The US growth trajectory will be key. If it remains above the real (inflation-adjusted) cost of servicing debt, US growth may help sustain fiscal deficits or potentially improve the budgetary balance, as it did in the aftermath of the Great Financial Crisis.
Seizing opportunities in fixed income
Equity earnings yields, at about 4% for the S&P 500, are in decline in the US, and US Treasuries offer comparatively higher, and less risky, yields of 4.7%. Recent weaker economic data supports the attractiveness of bonds versus stocks, as the relative performance of stocks versus bonds has recently outpaced the deteriorating fundamentals. This supports our preference for fixed income in multi-asset portfolios.
Current yield levels can also make corporate credit attractive. However, both investment grade and high yield spreads are very narrow, compared with historic levels, and offer only limited returns for their risk. As such, we continue to hold exposures in line with our strategic asset allocation levels. We have recently raised our exposure to emerging market bonds in hard currency to strategic levels, as yields now compensate for their risks. Within these assets, we prefer corporate bonds, given their better diversification and yield premium advantage over sovereign debt. Risk-averse investors may wish to manage their portfolio sensitivity to interest rates or inflation risks either through short-dated or inflation-linked bonds, to complement or partly replace existing exposures. For more risk-tolerant investors, higher quality segments within high yield credit offer interesting risk-adjusted yields.
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