Global bond markets face uncertainty amid geopolitical tensions

Set against a backdrop of sustained global geopolitical and economic disruption, the world’s bond markets are moving through a period of great uncertainty.

In the short term, there are questions as to whether yields have peaked as central banks pull the levers of interest rates to temper inflation without depressing economic growth.

In the longer term, the rise of the Global South through new trade routes and multilateral economic agreements is shifting economic power away from the developed economies.

The recently announced India-Middle East-Corridor reflects the scale of ambition and optimism across the developing markets – many of which are experiencing rapid economic growth thanks to their newly liberalised capital markets, national diversification strategies and large inflows of capital.

The new corridor, revealed at the G20 summit in India this year, would create two new trade routes linking India to the fast-growing GCC and then on to Europe.

Once it makes progress, its physical infrastructure, data networks, ports and gas pipelines will deepen economic and political ties between East and West, with the high-growth GCC countries acting as a de facto gateway for the economic interests of 1.4 billion people in the Global South.

Capital raising for such development will be critical and we may well see nations tapping bond markets to facilitate this corridor. Moreover, the Middle East’s economic power base is to be further bolstered by Saudi Arabia and the UAE joining the Brics group in January.

The challenge for investors is to make sense of these rapidly changing global dynamics during a period of historic debt, sluggish growth and political uncertainties in the developed economies.

For the bond markets, these confusing signs are giving rise to disparate views on performance, creating a lack of consensus between bulls and bears.

Bond bulls argue that today’s yield of about 5 per cent on the 10-year bond incorporates an extended pause by the US Federal Reserve at current policy rates, with a sizeable real (net-of-inflation) yield of close to 2.5 per cent.

This would bring yields on 10-year bonds close to pre2008 highs.

However, bond bears argue that for yields to return to a normalised curve with long maturity yields above short maturity yields, the 10-year yield must rise above an extended Fed policy rate of 5.5 per cent, with a still-robust US economy. Such a move would be in sharp contrast to what we typically see in a late cycle when the yield curve normalises in response to a sharp fall in short-maturity yields precipitated by a downturn that prompts the Fed to cut rates.

Whether US bond yields have peaked amid a still-robust US economy remains a key debate in markets.

US growth accelerated in the third quarter of 2023 to an annual 4.9 per cent on strong summertime consumption.

However, growth will probably slow significantly in the coming quarters amid tightening financial conditions from the lagged impact of 525 basis points of rate increases since March 2022 and the fading impact of pandemic stimulus measures.

An elevated risk of recession in the eurozone and tight financial conditions across the EU and UK suggest that the European Central Bank and the Bank of England are unlikely to increase rates further as they nurture growth.

Within the EU, major economies such as Germany have suffered contraction, particularly in manufacturing – Germany is particularly exposed to China, whose slowing growth dampens exports.

All of these factors combined mean we continue to see an attractive risk/reward in high-quality government bonds – and we retain an overweight stance to developed market investment grade government bonds within our diversified allocation.

Historical performance shows that bond yields tend to peak not far from the peak in the Fed policy rate, which we believe has been reached. Today’s yields, therefore, offer an opportunity to lock in the highest real yield since 2008.

There is, of course, the possibility that yields could rise again in the short term if curve normalisation occurs through unchanged short-maturity yields and rising long-maturity yields with the Fed holding rates.

However, a further significant rise appears unlikely, given cooling inflation and rising signs that borrowing costs are biting into household budgets.

As we head to peak rates amid falling inflation, subdued consumption and weakening global growth, the big bond debate is likely to be won by the bulls.

Whether US bond yields have peaked amid a still-robust US economy remains a key debate in markets