Central Banks’ Significant Pause Encourages Struggling Bond Investors to Double Down – Reuters

By Naomi Rovnick and Yoruk Bahceli

LONDON (Reuters) – Bond investors who have faced challenges during a record cycle of interest rate hikes are starting to increase their holdings, believing that central banks may be finished with rate increases and could soon cut rates instead.

On Thursday, the Bank of England joined the U.S. Federal Reserve, which paused rate hikes the day before, in maintaining its current rates for the second consecutive month in an aggressive effort to combat rising inflation. Similarly, Norway also opted to keep rates steady, and the European Central Bank paused its rate increases last week, marking its first halt since July 2022.

This trend is reassuring for bond investors, who have experienced a loss of approximately 2% in global government bond indices this year following a record 13% loss in 2022. Initially, many bond investors anticipated a decline in inflation and economic growth that would lead to swift rate cuts. However, as labor markets remained tight and central banks continued to emphasize that inflation was still too high, bond performance fell short of expectations.

U.S. Treasuries have seen a decline in value for six consecutive months—the longest stretch of losses in two decades, according to Deutsche Bank—leading to increased yields as they move inversely to bond prices. However, on Wednesday and Thursday, government bond yields in the U.S. and Europe experienced a significant drop, fueled by speculation that the Fed’s tightening period may be over.

The current extreme increase in bond yields since the summer has prompted fund managers to expect that tightening financing conditions will exert enough pressure on economies to slow even the robust U.S. economy, leading to rate cuts next year. Gregoire Pesques, Chief Investment Officer of global fixed income at Amundi, Europe’s largest fund manager, noted signs of an economic slowdown already emerging in Europe, predicting a similar outcome for the U.S.

While maintaining a neutral position on European government bonds, Pesques indicated interest in increasing his allocation to U.S. Treasuries from an underweight stance.

UNFAIR VALUATIONS?

Current inflation levels and rising interest rates diminish the appeal of bonds, as they reduce the value of fixed coupon payments compared to cash. This situation has led some investors to double down on bond investments, particularly as 10-year Treasury yields recently surpassed 5% for the first time since 2007. The rise in yields, which have increased approximately 150 basis points from their lows in April, could potentially accelerate an economic slowdown. Fed Chair Jerome Powell remarked on the reflected impact of these changes on real-world borrowing costs.

In Europe, Germany’s 10-year Bund yield has climbed about 75 basis points since late March, now at 2.7%. Some investors believe government bonds are undervalued based on future interest rates and inflation expectations. Gurpreet Gill, a fixed income macro strategist at Goldman Sachs Asset Management, noted that valuations now appear much more attractive than a few months ago.

Goldman’s investment arm currently holds a neutral stance on Treasuries, but Gill expressed increased confidence that further rate hikes are unlikely compared to previous months when investors anticipated additional tightening by year-end. Nikolay Markov, lead economist at Pictet Asset Management, estimated a fair value for Treasuries around 4%, partially based on his projection of U.S. core inflation dropping to 2.5% by the end of 2024.

Market participants remain hopeful that inflation will continue to ease as economic conditions weaken, fostering expectations of substantial rate cuts next year. Even in the U.K., where the Bank of England has ruled out immediate easing, traders have shifted their timelines for a first rate cut to August.

Fidelity International’s fixed income portfolio manager Becky Qin mentioned a growing bullish sentiment towards developed market debt, specifically UK gilts, anticipating that an economic slowdown would coax a more dovish approach from the Bank of England. Similarly, Georgina Taylor, fund manager and head of multi-asset strategies at Invesco, noted the firm’s recent move into gilts, suggesting that the Bank of England could lead other major central banks in making cuts.

INFLATION RISKS STILL THERE

Bond investors may be taking a gamble by assuming that rate setters will end their inflation-fighting measures, especially given the persistent high inflation that could escalate, particularly with geopolitical tensions affecting energy prices.

Shamik Dhar, chief economist at BNY Mellon Investment Management, cautioned that risks to interest rates remain skewed to the upside, given that inflation is still above target levels. Even in the U.K., where growth expectations for 2024 are low, Dhar emphasized the necessity of seeing significant progress on inflation to support a substantial bond market rally.