In Europe, mounting expectations that the European Central Bank will hike rates by a further 75bps in October helped to send yields on 10-year Bunds 9bps higher to 2.09% on the day, to reach their highest levels since the Eurozone debt crisis in 2011. UK gilts also tumbled further on concerns over debt sustainability in the wake of last week’s budget announcement, with yields on 5-year gilts up by 48bps on Monday to a post-2008 high of 4.52%, following on from the 51bps rise on Friday.


Global bonds are now in bear market territory (–20% decline from their peak) for the first time in more than 70 years.


Rising yields in part reflect the unwinding over the last month of expectations for an early pivot in central bank, and particularly Federal Reserve, policy. But we think the rise in longer-term yields may not accurately reflect the risks facing the economy:


  • The Fed continues to stress that controlling inflation is its priority…On Monday, Fed officials reiterated the central bank’s hawkish stance. Cleveland Fed President Loretta Mester said that it is more costly to do too little to rein in inflation than too much. Atlanta Fed President Raphael Bostic highlighted that, “The more 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 in the marketplace in all directions.”
  • …and the short end of the yield curve is fully priced for a front-loaded hiking cycle. Fed fund futures pricing, which suggests a peak next May at 4.62%, is aligned with the FOMC dot plot, which estimates a terminal fed funds rate of 4.6% in 2023. Two-year Treasury yields at 4.27% have increased by 88 basis points since Fed Chair Jerome Powell’s hawkish speech at Jackson Hole a month ago.
  • But longer-term yields may have run too far. The steepness of the recent rise in yields has pushed up real yields, tightening financial conditions and increasing the risk that the US economy tips into recession. In our view, US 10-year Treasury yields at 3.84% (as of Tuesday morning) are likely already close to their highs for the cycle and our end-year 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 high, this will likely increase the potential severity of any future recession and raise the demand for hedging assets like long-term bonds. We expect 10-year yields to fall to 3.25% by June 2023.

So, after the move higher in global interest rates and credit spreads this year, and with markets already pricing in an aggressive central bank tightening cycle, the risk-reward in fixed income has become more favorable. The best approach, in our view, is for investors to focus on the higher quality segments (US agency MBS) of fixed income where outright levels of rates currently provide a significant margin of safety against potentially further moves higher in rates. Starting yields are attractive and are often a good predictor of forward returns. Second, there are opportunities surfacing in the credit space as spreads widen. We suggest a selective approach where investors focus on issuers that are robust enough to withstand a more challenging macroeconomic backdrop.


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


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


Original report - Rising bond yields create fixed income opportunities, 27 September 2022.