With the focus shifting from interest rate cuts to the likelihood of rates staying higher for longer, Steve Ryder and Daniel Bright assess the possible outcomes and implications of higher rates and monetary policy divergence in debt markets.
Read this article to understand:
- The drivers and investment implications of monetary policy in Europe and the US
- Potential risks of the large US deficit and increased Treasury supply
- Why diversification in bond portfolios is growing ever more important
As any long-distance runner will tell you, the last mile can be the toughest.
Central bankers know the feeling. After two years spent trying to bring inflation under control, they have had some success. But the battle with rising prices is not over yet.
Since the start of 2024, global growth has continued to show positive signs of health, with surprises to the upside despite high interest rates. US economic data remains resilient, with GDP growth on track for around three per cent in the second quarter.
However, inflation is proving sticky in many economies – particularly in services sectors, which are demand-sensitive. This has resulted in monetary tightening being delayed and led markets to continuously reassess the likely number and extent of rate cuts this year.
Not surprisingly, bond markets have proved somewhat volatile over the period, in the US in particular. This has put upwards pressure on yields of sovereign bonds globally, as the higher-for-longer environment in the US had a knock-on effect on expectations for the direction of rates in other developed markets.
With inflation coming under control faster in Europe than the US, a divergence in monetary policy has slowly emerged
However, with inflation coming under control faster in Europe than the US, as well as the former’s weaker growth outlook, a divergence in monetary policy has slowly emerged. Two of the G10 economies – Switzerland and Sweden – cut their main interest rates (in March and May respectively) and were followed in June by the European Central Bank (ECB), which lowered its benchmark deposit rate by 25 basis points to 3.75 per cent.
So, what are the implications of these themes for fixed-income investors? In this Q&A, Steve Ryder (SR) and Daniel Bright (DB) of our sovereign bond team offer their outlook and argue that greater divergence between economies means diversification in bond portfolios is growing ever more important.
Rate cut expectations have been dialled back significantly since January – particularly in the US. What has been the impact on market sentiment and how do you see it evolving over the rest of the year?
SR: After the good progress made on tackling inflation towards the end of 2023, particularly in the US, inflation proved “stickier” than was expected in the first few months of this year. The US Federal Reserve (Fed) was disappointed to see not one, but three inflation upside surprises in the first quarter, calling into question its progress on bringing inflation to target, and hence the rationale for policy easing. Even though subsequent consumer price inflation (CPI) readings came down slightly (the latest figure is 3.3 per cent year-on-year in May), together with other signs of strong economic activity, these have cast further doubt on the number and extent of US rate cuts in 2024.
Bond markets have been volatile in the first half of the year because of the uncertainty surrounding rates outlook throughout the period. Although the bulk of the bond sell-off was US-led, as investors began pricing out the expected Fed rate cuts, there has been some spillover into the rest of the world. But resurgent inflation has mainly been a US story. The picture in other developed economies is somewhat different: inflation continues to fall in many other countries. The pace of the decline, however, is now the main concern.
We are starting to see policy divergence between the US and Europe; the ECB cut rates in June, while Sweden and Switzerland did so a little while earlier. What are the implications for the markets?
SR: Policy divergence has been a key theme for us for a while. Following the synchronised hiking cycle across most developed markets to combat the global inflation shock, we were sceptical of the idea that major central banks would all ease at roughly the same pace and magnitude. Similarly, it was always unlikely that central banks could bring policy rates down to neutral (a rate that neither stimulates nor restricts economic growth) without any mishaps – the perfect “soft landing” in other words.
In Q1, with concerns that US inflation was rebounding amid a still-tight labour market, we felt US underperformance versus the rest of the world (including Europe) was an attractive theme. Markets caught up to this view, and prices moved to reflect the expectations of a higher-for-longer regime in the US, and that rate cuts are likely to be pushed back. In April the spread between euro-zone and US ten-year bonds broke out to multi-year highs – reaching 218 basis points on April 16.
Since then, the narrative has completely reversed. Inflation is gradually falling in Europe but growth, wages and services inflation have all been higher than the ECB expected. Meanwhile, in the US, there have been growing concerns around the risks of a more material downside in the labour market.
Sticky underlying inflation in Q1 is a pattern seen across developed markets: perhaps US inflation surprises were not unique to that market, and possibly related to the easing in global financial conditions. Regardless, for 2025 and beyond, we think further US economic resilience will limit how far European policy can diverge.
DB: In the UK, services inflation is still too high, at 5.7 per cent in May, coinciding with persistently strong wage growth (six per cent in the three months to March), despite a softening jobs market. Even though GDP growth is showing signs of improvement, it is still well below one per cent.
Despite the relatively tight labour market, we expect policy to be loosened as we progress throughout this year. It was widely expected that over the summer months headline inflation would fall to around the two per cent mark, which duly happened in May, increasing the pressure on the Bank of England (BoE) to cut rates.
Investors are now expecting two cuts by the end of the year. While there are some risks to this scenario given the sticky inflation picture, overall we believe conditions will merit a dialling-back of policy restrictiveness. However, unlike the ECB, which was willing to communicate its intention to deliver its first cut in June, the BoE has been more reticent, leaving the markets to guess the timing of the first cut, which is now expected in August or September. Another major economy, Canada, cut rates on June 5, from five per cent to 4.75 per cent.
This year, bond investors have focused mainly on inflation and the path of interest rates. Are they missing potential risks associated with the huge government deficit in the US?
DB: The US Treasury released detailed borrowing plans for the next quarter on May 1, and by the afternoon of that day bond yields were left unmoved – a very different reaction to previous occasions. If we wind back to August of last year, the borrowing announcement (July 31) managed to spook the markets for a variety of reasons.
One was the news that the Treasury would increase the issuance of what it calls “coupons” (any bond issue with a maturity longer than one year) quite dramatically.1 This was partly because of the need to rebuild cash balances after the US debt ceiling drama over the summer of 2023 – a political wrangle over the amount the government can borrow – which caused the Treasury to take extraordinary measures to keep the government open and avoid default.
Another was the high US deficit ($1.69 trillion in 2023), which is not expected to come down anytime soon and must be funded.2 Hence investor concerns around who would step in to buy all the issuance now the Fed has stepped back and is reducing its balance sheet through quantitative tightening (see Figure 1).
Since that episode, the US Treasury seems intent on minimising disruption, aiming to be stable and predictable, and show a willingness to adapt its bond supply programme to market conditions. In November it outlined a slightly more conservative programme, which was one of the catalysts for a big rally, and signalled there was to be one more increase in issuance volumes, after which the level would remain stable for subsequent quarters. Thus, the January and May borrowing announcements came in line with expectations.
While this mitigates one of the risks in the near term, US elections are adding to uncertainty around the country’s public finances.
Figure 1: Movements in the Fed’s balance sheet since before the pandemic ($ trillions)
Total assets (less eliminations from consolidation): Wednesday level, US$ millions, weekly, not seasonally adjusted.
Source: Aviva Investors, Federal Reserve Bank of St. Louis. Data as of June 12, 2024.
SR: I would add that the supply of Treasuries on its own is unlikely to be a big concern. Supply is a concern when there is not enough demand, and demand is driven by the outlook for policy and inflation. If inflation continues to fall in the second half of this year, that demand backdrop will improve, and I believe there is enough cash and demand for Treasuries to meet the increase in supply.
The problem in Q3 last year was that supply was being ramped up at exactly the same time that growth was being revised higher, which meant expectations for policy rates were moving higher – a perfect storm.
A major change in the US market over the last few years has been that there are now fewer “price-insensitive” buyers. For most of the last decade there were buyers of Treasuries to meet various objectives such as quantitative easing (QE) programmes, reserve accumulation, regulatory purposes or bank demand.
One by one, many of the structural demands have changed and what we are now left with is a more “price-sensitive” buyer base. This means investors do not have to buy and take down the new supply. If inflation is a concern, they may hold off. Of course, there is still an argument that a near five per cent nominal Treasury yield is quite attractive on a long-term basis for some investors. However, the closer we get to the US election, there may be new concerns around fiscal policy going forward. And if the inflation outlook is not under control, then that would be a real worry.
What is your outlook for major currencies? Will the strength of the US dollar and the weakness of the Japanese yen persist? What about the euro?
SR: While there are a few factors contributing to the strength of the US dollar, the main reason is the remarkable growth and strength of the US economy relative to other regions. High US yields and a “flight-to-quality” factor driven by global geopolitical concerns add further to the appeal of the currency.
Considered in this light, the dollar is moving higher on perceptions of US exceptionalism: its strength is largely driven by policy divergence and interest-rate differentials between the US and other countries. The dollar index, which measures the currency’s strength against six of its peers, is up by 3.8 per cent year-to-date (to June 14) as the greenback has gained against just about every other major currency in 2024.3
As for the yen, although Japanese interest rates were raised out of negative territory in a historic move in March, there is still a huge rate differential with the US, given that the key interest rate in Japan is now 0.0-0.1 per cent, while the federal funds rate is at 5.25-5.50 per cent. Further, while the US is on its quantitative-tightening journey, the Bank of Japan is still conducting QE. On this basis, the current level of dollar/yen seems reasonable.
The story for the euro is similar, with the policy divergence increasing as the ECB cut rates in June before the Fed. The interest-rate gap between the US and the euro zone is thus set to widen, putting downward pressure on the euro against the dollar.
However, there is currently a broad debate around how much central banks can ease policy if the Fed remains on hold, and how policy divergence is likely be hampered by exchange rates. If other countries were to dramatically ease policy before the Fed, it could weaken their currencies and import inflation as a result. This would then limit the quantum of easing that they need to do. We are sceptical that this will be the constraint on divergence, however, with it being more likely that a strong US economy supports the rest of the world (or vice versa).
DB: Though we believe the timing of a Fed cut does not necessarily influence the timing of the first cut in other markets, it will potentially have more of an impact on the speed and extent to which others can cut interest rates. As Steve mentions, FX is just one of the channels which could influence the path of interest rates.
How important is diversification in the current environment, and which geographic regions do you favour?
SR: Given the uncertainty surrounding inflation globally, higher deficits and changing supply and demand patterns, the importance of diversification is clear. Diversification allows investors to reduce idiosyncratic risks.
We believe that, going forward, there will be a lot more dispersion in global developed markets. As discussed earlier, while in the last few years there was a synchronised tightening cycle, with most countries seeing higher bond yields and policy rates, we should see a lot more dispersion as policy begins to normalise over the next couple of years. This means there will be a lot more potential to seek excess returns. Through a global approach we can spread out the risk and be much more selective in allocations.
