Bond investors may find themselves in a favourable position for the remainder of 2023 if market indicators accurately predict that central banks will tighten their policies excessively, leading to a potential recession. Although headline inflation has eased, underlying pressures remain high, prompting central banks to maintain a hawkish stance. In June, Canada resumed tightening its monetary policy, while Britain and Norway made significant moves in the same direction.
Moreover, officials from the U.S. Federal Reserve and the European Central Bank signalled their intentions to implement more interest rate hikes at the recent Sintra forum.
As a result, markets are now anticipating a 25 basis point increase in the Federal Reserve rate, likely to take place in July. Additionally, there is a 30% chance of another hike by November. These expectations have led investors to reduce the number of rate cuts they previously anticipated for next year. Meanwhile, the market has priced in two more rate hikes by the European Central Bank, bringing the rate to 4%. This is a notable change from the earlier projection of a single hike to 3.75% made in June. Furthermore, the Bank of England is expected to raise its main rate to approximately 6.25%, surpassing the previous estimate of 5.5%.
In addition to these developments, the yield curve inversion, which occurs when shorter-dated bonds offer higher yields than longer-dated ones, has deepened as yields on shorter maturities surge.
For example, U.S. 10-year Treasuries are currently yielding 104 basis points less than two-year peers.
This marks the largest difference since the banking sector turmoil witnessed in March and nearly approaches the deepest inversion since the 1980s. Similar patterns are observable in German and British debt.
Mike Riddell, a senior fixed income portfolio manager at Allianz Global Investors, notes that the yield curve is indicative of extremely tight monetary policy.
Riddell believes there is significant potential for a bond rally and suggests that risky assets are underestimating the risk of a recession or other unfavorable events. Consequently, Riddell’s position reflects concerns regarding a policy error.
A potential reversal of central bankers’ policy overreach would be welcome news for investors in global government bonds. Data from the Commodity Futures Trading Commission (CFTC) indicates that investors have accumulated bets on falling U.S. bond prices.
Consequently, any shift in sentiment could trigger a substantial rally, thereby boosting returns that have been less than 2% year-to-date following a 13% loss in the previous year.
An early indication of an improving bond outlook emerged last week with data showing that business growth in the euro zone stalled in June. This led to a significant drop in German bond yields, as bond prices move inversely to yields.
However, interpreting economic data has become increasingly challenging.
Yields surged on Thursday due to higher-than-expected first-quarter growth in the United States and German inflation.
Investors who remain vigilant for policy mistakes fear that central bankers are basing their decisions on backward-looking data, such as inflation, without fully considering the impact of previous rate hikes and signs of impending disinflation.
One critical indicator of broader inflation trends is producer price inflation. In May, it declined to 1% annually in Germany and 2.9% in Britain, reaching the lowest levels in over two years. Similar decreases have been observed in the United States.
Despite this, Vanda Research’s global macro strategist, Viraj Patel, notes that the current decline in producer price inflation seems to be disregarded, contrasting with the emphasis placed on its increase a year earlier.
In conclusion, bond investors could benefit if market indicators accurately predict that central banks will overstep their tightening policies, potentially leading to a recession.
The anticipation of further interest rate hikes by central banks has influenced market expectations and investor behaviour.
However, the interpretation of economic data and the potential for policy errors add complexity to the situation.
As the year progresses, investors will closely monitor these factors while positioning themselves for potential opportunities in global government bonds.
