Investment Institute
Viewpoint CIO

Curvy

  • 14 July 2023 (3 min read)

Inflation is easing back. This is most obvious in the US where headline inflation slowed to 3% in June. If the Federal Reserve (Fed) raises rates again in July, implied real interest rates for the year ahead will be well above those realised over the last decade. As such, there is justification in the market looking for lower interest rates in 2024. That would mean a steepening of the yield curve and positive returns from bonds.

Falling inflation

Investors welcomed the decline in US core consumer price inflation (CPI). It was the first time the core CPI monthly increase had been below 0.2% since August 2021. It was also below the average of all the June increases in the index going back to 1989, in what might be a sign of easing momentum in the core price level. It is only one month of good data, of course, but if the index normalises to its historical pattern, core inflation, measured year over year could be down to around 3.5% by year-end. Headline inflation is likely to be below 3%. The Fed should be pleased with that outcome. However, it will want to be sure that further declines in inflation, towards the 2% target, are on track in 2024. To be sure of that, the Fed has continued to suggest that rates will remain high. Nevertheless, the market has started to price rates cuts for early 2024.

Real rates rising

In July 2022, US one-year interest rates were around 3%. Headline consumer prices have increased by 3% since then. Real interest rates, ex-post, have been zero. That is not the case now. Rates for one-year, as indicated by the current level of Treasury Bills, stand at 5.3%. Inflation over the next year could be around 2.5%. Thus, ex ante, real interest rates are very much in positive territory. The persistence of inflation above the Fed’s target will determine what happens to real interest rates in the years ahead. If inflation continues to moderate, real rates can come down over the next year or so, which means lower nominal rates. Monetary conditions are tight in the US and the case for relief will build over the coming months if the current disinflation phase continues.

Curve steepening

As such, the yield curve is likely to continue to dis-invert. The gap between 10-year and two-year yields recently reached -108 basis points (bp). The extent and length of time of the inversion are key indicators of slower economic growth (and lower interest rates ahead). Yields on two-year Treasuries are 4.6% now. The forward (one-year) rate for two-year yields is 3.75% and the forward (two-year) yield is 3.5%. The market is anticipating the easing cycle, meaning short-term rates will fall more than longer-dated yields. A normalisation of the yield curve means a movement of between 80bp and 100bp over the next year or so. Government bond investors are likely to be all over that opportunity, driven by the need to bring short-term rates down in real terms.

Treasuries outperforming?

Related to this is the likelihood that US Treasuries will outperform other major government bond asset classes. German and French government bonds have slightly outperformed US Treasuries (in the seven-to-10-year maturity range). However, the European Central Bank has more to do to bring inflation down. Market based inflation expectations for Europe have (upwardly) converged on US medium-term expectations (around 2.6%) indicating some de-anchoring of inflation expectations in Europe. The situation is worse still in the UK, with inflation at 8.7% in May and the market expecting the Bank of England (BoE) will need to take rates to over 6%.

UK distressing

UK government bonds have had a torrid year. The full market index delivered a total return of -3.85% in the first half of the year. Ten-year gilt yields reached 4.66% in June, higher than the peak seen last Autumn when then Prime Minister Liz Truss and Chancellor Kwasi Kwarteng played fast and loose with fiscal policy. The rise in market rates is devastating the housing market through the re-setting of fixed rate mortgage deals. In June, the RICS Housing Market index fell to -46%, its lowest level since the global financial crisis, when big chunks of the UK financial system melted down. So far, the market has not been able to price any rate cuts in 2024 and is pricing a medium-term retail price inflation rate of 3.6%, equivalent to a CPI rate of just under 3%. The consensus forecast for the UK economy is negative annual growth this year and barely any recovery in 2024. The UK faces a miserable combination of growth and inflation over the next year. Perhaps enough to provoke the electorate to vote for a change in government once a general election comes along.

But gilt performance improves

Gilts might be a buy though. Lots of bad news about inflation and policy rates is priced in. The probability of a UK recession is rising, driven by the expected impact of a housing collapse and a mortgage payment squeeze on household incomes. There is a scenario in which the BoE must pivot aggressively next year in response to weaker growth. A lot of the gilts in issuance trade on a price well below par, including the current benchmark 10-year issue (90.7p with a yield to maturity of 4.45%). The premium of UK gilts over US Treasuries is around 64bp currently, its highest since the 2008/2009 crisis. From a strategy point of view, a bullish expectation on US rates should feed across to a positive view on gilts as well, with the additional spread providing some return cushion. One caveat is the fiscal position, however. The latest comments from the Office for Budget Responsibility paint a damning picture of UK government finances and its debt profile. Lower inflation and rates will partly alleviate these concerns.

Central bank watching 

Inflation does seem to be coming down. Getting inflation back to central bank targets will be difficult though. There is no sign of the central banks abandoning those targets so it may mean that they need to squeeze demand enough to change the inflationary expectations on wages and pricing that have built up over the last two years. Such a scenario is even more bullish for bonds, even if it means higher short-term rates. The pattern of inflation and central bank responses in the next six months will be very revealing as the nirvana of returning to long-held inflation targets comes closer. Of course, one scenario is that real rates will need to be higher than they have been in the last two decades. Forward interest rate pricing suggests a real rate over the medium term of around 1%, which seems more reasonable than the repressed real rates of the quantitative easing period. This will allow nominal rates to fall and the yield curve to dis-invert. This is a bullish outlook for bond investors.

(Performance data/data sources: Refinitiv Datastream, Bloomberg). Past performance should not be seen as a guide to future returns.

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