What’s wrong with long-end bonds?
Rising government bond yields have become the subject of headlines. James Bilson, Global Fixed Income Strategist at Schroders, considers this, and what needs to happen to support long-end yields.
Sovereign borrowing costs are in the news. Yields have risen significantly, especially for longer-dated bonds, across the world.
But we believe there has been some misdiagnosis of the root causes - and thus necessary solutions - that brought us here. In this note, we discuss our thoughts on the drivers, the solutions, and the outlook for bonds from here.
This is not a fiscal crisis (yet)
Fiscal policy is important to bonds. Very important. But unlike some recent commentary, we don’t see any evidence the rise in yields is being driven by an increase in sovereign credit risk.
In the US, which has among the worst fiscal debt trajectories of any major economy, long-end yields are rising less than short-end yields. US treasury bonds are outperforming swaps, and international peers. US sovereign CDS have fallen over recent weeks. None of the above is consistent with the explanation that rising yields are being driven by increased concern over US creditworthiness.
This is not to be complacent about the future risks of sovereign credit risk, or saying concerns over debt dynamics are not valid. They are. Debt trajectories among developed nations variously range from the bad to the very challenged. We simply see very little evidence that has been a factor in recent pricing.
Moreover, the market focus on these fiscal sustainability dynamics is highly contextual – when inflation is low or moving lower, these fears can (and will) recede. When inflation is too high or policy is tightening, they quickly resurface – as now. In other words, fiscal fears tend to move either in virtuous or vicious circles.
So, if not fiscal credit risk, what is causing the recent repricing in bonds? In our view, the true reason for the recent rise in global yields is somewhat more banal.
Combined policy is too loose to deliver sustained 2% inflation
This, in one line, is the root cause of the current weakness in bonds. Solve inflation, and many other problems become much easier too.
The starting point is simple and well documented: global supply capacity has been hampered by various shocks, most recently in the Middle East, and private sector investment demand is exceptionally strong as generational-level investment in AI infrastructure coincides with a global manufacturing boom in “old economy” sectors, in no small part linked to a global desire to build greater defence capacity and energy security.
With this private demand backdrop, monetary and fiscal policy is too loose to sustainably deliver 2% inflation, especially in the US.
We think this combination of policy is crucial – what matters is not monetary policy in isolation, but how fiscal and monetary policy are interacting. If fiscal policy was withdrawing demand from the economy, monetary policy would be more than tight enough to hit inflation remits. But it’s not, so it’s not.
To our eyes, this explains the real importance of fiscal policy in the recent rise in yields: less about sovereign credit risk, and more about creating too much demand for the economy to cope with. The net result is above-target inflation. Without fiscal restraint, tighter monetary policy must be the balancing factor. It’s the release valve.
What needs to happen to stop long-end yields rising?
Unfortunately, we are unable to magic inflation away. As fixed income investors, our lives would be significantly easier if we could. So what are we watching for instead?
1 ) Solving the energy disruption
A resolution to the conflict in the Middle East, allowing energy flows to normalise towards pre-war levels, would be a very significant help. Whatever the geopolitics of this conflict, from a macroeconomic viewpoint it is a pure supply-side constraint - the speed limit of growth we can have without creating above-target inflation is lower.
If this supply constraint was lessened (or better still, removed) the level of demand we would need to curtail to bring supply and demand back into balance would also be lower. In other words, less policy tightening would be needed - be that monetary, or fiscal (we come to this distinction next).
2) Restoring the Fed's 2% inflation target credibility
True support for long-end bonds would come not simply from the Fed delivering tighter policy to deal with the inflation problem. This may sound counterintuitive: how would tighter monetary policy be positive for bonds? For shorter-dated bonds, the simple answer is it wouldn’t. Tighter Fed policy means higher yields in the 0-5y segment of the curve. But for longer-dated bonds, we believe that greater inflation fighting credibility would counteract the impact of higher short-end yields. We would expect significant flattening of the yield curve and at long-enough maturities, could even see outright yield declines as a result of tighter policy.
Put another way, the greatest threat to long-dated bonds is not tighter short-term policy, it is a Fed that appears uncaring about higher inflation. At the time of writing, a hike in September is a close call, but marginally more likely than not.
3) AI boom rolls over
Private investment is incredibly strong. In effect, in a reversal of how we usually use the term, it is the AI hyperscalers ”crowding out” public sector borrowers- forcing sovereigns borrowers to pay higher yields in a ”competition for capital”.
If, for whatever reason, this surge in private sector investment demand were to weaken, it would be a notable moment for bond markets and take significant pressure off long-end sovereign yields. However, a sharp reduction in AI infrastructure capex doesn’t seem likely in the near-term. The upward trend seems strong, and possibly even strengthening.
We’d consider this a high-impact, low-probability event.
Thinking long and short-term: how does this affect our portfolios
It is worth separating structural and tactical considerations here.
As the above makes clear, we remain concerned that many of the structural drivers that have driven long-term bond yields higher globally – fiscal deficits, huge AI-related capex and bond issuance, persistent above-target inflation – have not been solved. Of course, with higher starting yields, we are better compensated for these risks, but we will need more definitive proof the underlying causes are resolved before we are confident that a structural top in long-dated bond yields has been reached.
But even while these concerns about longer-term dynamics for bonds linger, significant tactical rally opportunities exist. Short-term bond sentiment is now deeply, even extremely, negative: the sheer number of media reports in recent days about multi-decade high bond yields is testament to that. Thus, the hurdle for relatively ”better” news for bonds in the short term is, in our view, low. And with the market pricing a near 50% probability of three or more hikes from the Fed, combined with our view that the inflation overshoot is mild, rather than severe, we see attractive tactical opportunities in global duration despite lingering concerns about the structural dynamics.
Finally, as is clear from the above analysis, different dynamics are affecting different parts of the sovereign bond universe. Things that are good for long-dated bonds, such as tighter central bank policy, are not good for short-dated bonds. Some countries require more fiscal restraint than others. Inflation outlooks differ by country.
The case for active management of sovereign bonds is strong: being in the wrong geography, or the wrong part of the yield curve, could be costly.
Further reading : What’s wrong with long-end bonds?