We started the year with expectations of rates remaining elevated and growing evidence of increased divergence across bond markets, as investors and policymakers reacted to increasingly local growth/inflation dynamics. Markets have pondered the possibility of rates staying “higher for longer” on several occasions since the inflation shock of 2021 – 2022, only to look for signals of any easing to prompt market rallies, such as in the last quarter of 2023 and last summer. The question then is: will this time prove to be any different? And what can a bond allocation offer in a broader portfolio?
Vigilantes are back, capital flows could follow
There has been no shortage of exogenous shocks in the first half of this year. The US administration’s approach to tariffs escalated progressively, culminating in the “Liberation Day” announcement in early April. Further escalation ensued, upending decades of trade policy, until a temporary reprieve was announced. In this context, longer-dated bonds, rather than equity markets, acted as the disciplinarian, forcing the administration to rethink its approach. This could mark the return of the “bond vigilantes”, with fixed income markets imposing a degree of restraint on governments whose fiscal outlook is increasingly deteriorating. Even if some of the tariffs are walked back through trade deals, there is an increased probability of more economic nationalism and repatriation of capital. We could start to see capital outflows from US financial assets into global fixed income, which should imply higher risk premia and higher long-term bond yields for the US. In the rest of the world, this could be a strong technical factor to support non-US financial assets, with European, Japanese and Chinese fixed income potentially benefiting from US outflows.
Storing up trouble
We continue to expect heightened volatility in rates markets around longer-dated maturities. Yield curves across developed markets have now normalised but could see further steepening due to persistent inflation and high government spending. Growing concerns about debt sustainability could lead to higher term premia across developed markets, especially the US — a dynamic illustrated by Figure 1, which shows that, at the time of writing, the average term premium across developed markets had risen above 1.0% the first time in 11 years.