Sovereigns’ state

Read this article to understand:

• Drivers of interest rates in the developed markets over the next year
• Where to look for potential opportunities in global sovereign bond markets 
• Why global sovereign bonds are still beneficial as a diversification tool in bond portfolios

Inflation uncertainty and increased sensitivity to economic activity data created a volatile environment for global bonds throughout 2024 as periods of positive performance quickly reversed direction.

However, fixed income markets are broadly pricing in a soft landing in major economies over the next year. Inflation is still approaching central bank targets and while there may be further bumps ahead, without a major shock in economic growth or inflation, it is hard to see interest rates actually going higher.

Expectations for higher US growth are already elevated following the election of Donald Trump in November. In Europe, as the market focuses on the potential for accommodative policy as well as the downside risks posed by US politics, a complicating factor will be the German elections in February 2025 and whether a decision can be reached to adjust the debt break. The prospect of fiscal stimulus and more debt-financed investments in Germany should provide a positive impulse to growth in Europe.

Where are sovereign bond yields likely to settle? A lot will depend on the demand for bonds. However, Steve Ryder (SR) and Dan Bright (DB) believe that there are reasons why bond yields are attractive at current levels, despite concerns surrounding increased government deficits and the policy impacts of the new US Republican administration.

Despite two interest rate cuts, US Treasury yields have been rising since September. Sovereign bonds in other major markets have also been losing ground. What is driving this trend?

SR: The bond market has continued to oscillate this year as inflation uncertainty has persisted alongside an increased sensitivity to activity data. As we headed into Q3, weaker inflation and soft landing concerns switched to worries about growth, amplified by a weak US labour market, which seemed to be deteriorating more rapidly than expected.

The US Federal Reserve (Fed) cut its interest rate in September. Initially, markets reacted positively to the cut (rates declined along the yield curve) perceiving the Fed as ahead of the curve with earlier and fewer cuts in the future. Shortly after, a strong September labour report removed imminent concerns on growth, reversing the declines.

The final driver of the sell-off was the increasing probability of a clean sweep by Trump, a scenario that would likely lead to higher inflation via tariffs and deficit uncertainty from tax cuts, which initially led to higher yields. However, it was interesting how quickly the move in US rates reversed. We believe it was due to the “Trump trade” being well-positioned into the election. Another factor was the removal of event risk, which saw volatility drop.

DB: Yields have tracked economic surprises quite well over the last couple of years, making them a useful barometer. As Steve mentioned, the main reason for yields moving lower in Q3 was the potential softening of data in the US, reflected in economic surprise indices turning more negative over the quarter. But since September, data has been surprisingly more positively, which has also contributed to the rise in US yields. Figure 1 is a chart of Bloomberg’s US Economic Surprise Index, which shows the pattern quite clearly.

With the US presidential election over, what are the implications of Donald Trump’s proposed policies for the US and the global economy? 

SR: It is not easy to assess the potential implications of the policies announced over the election campaign with any certainty until the new administration starts in January 2025.

Broadly, tax cuts and deregulation can act as a short term sugar high, supporting economic growth. However, depending on what tax measures are implemented (between rolling over existing tax policies versus new corporate tax cuts) they could worsen and raise the fiscal deficit.

Offsetting the positive growth impulse from the tax cuts, tariffs could prove a near-term inflationary shock. The potential impact will again depend on the actual policies, the timelines to be imposed, and the order in which they are imposed, as well as if and how the rest of world retaliates. Despite the noise before the new administration comes into power, this is likely to become a big story in the second half of next year.

The curb on immigration – all things being equal – will likely mean a tighter labour market with lower supply of workers, which could arguably be inflationary too.

DB: Given the Republican sweep, with all three arms of the government under their control, the new administration has considerable freedom to shape policy in the way it wishes.

On tariffs for example, the debate is on whether the US employs a universal tariff on all trading partners or whether it will focus primarily on a few, with consensus for more limited tariff rises where the potential read-across to growth and inflation will be a bit more limited. However, tariff policy is in a state of flux and might take a few months for it to become clear. More generally, investors should expect an environment of heightened policy uncertainty over the next couple of years. 

Deficits seem to be rising relentlessly in most developed countries. What are the likely impacts on bonds and how worried should investors be?

SR: The US is currently running a high budget deficit, which is very likely to expand further and is unlikely to reduce. But the net fiscal impact is still uncertain, since we do not know what tax cuts are going to be implemented or what tariff revenues will be generated. However, a permanent shift higher in the debt-to-gross domestic product (GDP) ratio is likely to have a long-term impact on US Treasury yields.

We have seen early evidence of this in asset swaps over the last few years, where Treasuries are cheapening (lower prices, higher yields) relative to swap rates. This is because markets are pricing in a supply premium due to higher borrowing needs to finance the deficit. There is also a rise in the term premia – the additional yield that investors demand due to fiscal uncertainty. One of our core views this year has been about higher term premia, and we expect it to continue to rise gradually. 

Where are yields likely to settle? We believe a lot of that will be down to the demand for bonds, which will continue to be driven by inflation and growth expectations. However, there are reasons why bond yields are attractive at these levels despite concerns surrounding increased deficits from here.

DB: The cheapening in swap spreads is a global theme. Swap spreads are measured as swap rates minus government bond yields. Swaps are typically priced off the main official interest rate and are relatively constant. As well as interest rates, government bond yields are also influenced by the relative supply and demand for the asset class. 

Over the last couple of years, we have moved away from relative scarcity in government bonds to an environment where expanded deficits, among other causes, have prompted governments to increase issuance to record levels post pandemic. This is at a time when demand has shrunk from big participants such as large banks and financial institutions. It is because of this dynamic – more supply, less demand – that government bonds have cheapened (yielding higher) relative to swaps.

What are your thoughts on the path for interest rates? Will major central banks continue with their rate cutting cycle over the next year and how much will Japan be able to raise rates?

SR: We, and the market, expect further policy easing next year. This is also what central banks are telling us. At the start of the year, policy expectations were reasonably synchronised across countries. Over the last few months, we have seen more divergence, which has been our base case, as we move into policy easing being delivered rather than expected.

We believe monetary policy in the US is still restrictive and the Fed will need to take rates towards neutral gradually. Based on the uncertainty around the new administration, and on various other macro factors, we believe interest rate expectations in the US are slightly underpriced and there is potential for further easing to be delivered.

In the UK, there is also uncertainty on the impact of fiscal policy. Much will depend on a continued progress on inflation and the impact of some of the newly announced government measures. We believe UK policy is restrictive, while there are signs that the labour market is weakening. However, we can see the Bank of England being patient before the potential to speed up policy normalisation as we move through next year.

Europe is facing potential impacts from US tariffs. While difficult to determine, the risks are to the downside. However, inflation has continued to fall, and the risk of an undershoot means there is a need for a more accommodative policy. We believe policy will be eased via consecutive cuts through to the summer of next year, but see the risks being to more easing in the short term.

DB: Japan stands out in contrast to Western markets, being on the other side of a neutral policy setting, with monetary policy still accommodative. We believe that the Bank of Japan (BoJ) is still on a path to normalise policy. But there are some upside risks for policy rates in Japan as real wage growth is feeding into consumption and the labour market is still tight.

Although the incumbent government had a poor showing in recent elections in October 2024, it looks like it will operate a minority government with support from other parties on a case-by-case basis. The price of the support could be additional fiscal stimulus measures.

European peripheral government debt, such as those of Italy and Spain, has been outperforming that of the core markets of Germany and France recently. Will the trend continue?

SR: The bigger macro story in Europe over the last couple of years has been the performance of the peripheral economies relative to the core. After the global financial crisis, focus turned on the northern countries such as Germany to lead the European growth recovery while peripheral countries lagged. Now, we see the opposite – a real positive momentum in Italy, Spain and Portugal’s economies, with a structurally weaker Germany.

Germany’s weakness is a structural issue with a drop in investment spending, and the country suffering from competitiveness and weak global trade. Meanwhile Spain, Portugal and Italy among others, have benefited from the European Union recovery funds as well as population growth. And with the strong nominal growth story, they have been able to bring down debt or certainly moderate their debt to GDP.

Thus, the recent tightening of spreads has been driven not by the periphery, but by weakness in Germany and France. Although, credit metrics for Germany are solid and there seems no need for a significant credit risk premium for bunds. Bunds have cheapened relative to swaps over the last year as net supply has continued to increase and is expected to continue. The move in Q4 saw this trend exacerbated by a spike in funding rates.

The same cannot be said for France. Last summer’s French elections resulted in a hung parliament split between three groups and the government has continued to struggle since. French 10-year OAT spreads have thus surged to the widest level since 2012 over bunds, reflecting concerns for fiscal and political risks.

DB: Interestingly this year, peripheral government bonds have performed in line with global credit spreads, which have also performed quite well.

Figure 2 shows the average spread of Spanish and Italian government bond yields over bunds versus European corporate bond spreads. The absence of any material idiosyncratic risks in peripheral economies has allowed their bond spreads to perform in line with corporate credit. This is interesting as one would have expected a bit more fragility given less support from the ECB this year as it began to wind back pandemic era bond purchases.

With increased risks of higher deficits and inflation in the global economy, why should investors include an allocation to global sovereign bonds in the current climate?

SR: Sovereign bonds are still providing an appealing income as the yield on global government bonds remains attractive relative to history – and also to equities – as evidenced by comparing US Treasury yields with the earnings yields on the S&P 500 index. 

The same applies on a standalone basis relative to other asset classes such as credit (corporate bonds) where spreads are currently at their tightest levels of the last few years.

Further, as well as the income element, we think there is still potential for capital appreciation next year, as in our view, interest rate expectations are underpriced and we will ultimately see more easing being delivered than is currently priced.

There is also the defensive nature of government bonds. We have seen a more positive bond/equity correlation in the last few years driven largely by a high inflation regime. But as inflation has moderated and continues to fall towards targets, the equity/bond correlation should shift to a more negative stance (as stocks go down, bonds should go up), allowing bonds to become more of a diversifier in portfolios. This is happening already, and the correlation has returned to the pre-COVID norm, which was expected as inflation risks recede (see Figure 3).

Going forward, we believe developments regarding economic growth will become more of a driver for the price of bonds and equities and hence the current negative correlation between the asset classes will become stronger.

DB: Given that much of the easing has now been priced out by the markets, there is less of a downside risk from a more hawkish policy stance than we saw in September.

While there are some fundamental risks with fiscal deficits, underlying inflationary pressures and still tight labour markets, we think that at current levels government bonds are comparatively attractive, given that equity multiples are at 10-year highs, credit spreads are very tight and there is reinvestment risk in cash as interest rates fall.

Where will you look for the best opportunities in your market over the next few months?

SR: We expect the focus for the start of 2025 to be on the new US administration's policy decisions and their impact on both the US and the rest of the world. For the start of 2025 at least, we expect modest growth and ongoing moderation in inflation across most regions to allow for further easing of monetary policy. However, we would not be surprised to see greater economic and monetary policy divergence as the year progresses and the global easing cycle matures, with geopolitics exacerbating this trend.

Central banks who moved more aggressively in 2024 may start to see the fruits of their labour in 2025, which should in turn motivate a slower pace of cuts or a pause in the cycle. We see the further gradual easing of interest rates alongside ongoing fiscal uncertainty to support steeper yield curves. Finally, we continue to expect Japan to proceed with gradual interest rate hikes, diverging further from the global easing cycle.

DB: This outlook means we continue to favour being overweight markets where we believe there are greater risks around the labour market such as the UK, New Zealand, and Canada. We believe there is a lot of negativity priced into Europe but while the fundamental outlook is weak, we should also acknowledge that the unemployment rate has reached new lows.

We are cautious on the US given policy uncertainty but will look at any weakness as an opportunity to enter long positions with the potential for downside risks to economic activity to emerge as we move through the year.