Further rate rises in the US may well be on the cards, economists have suggested, meaning the bond market might simply be “on hold”.
In its latest update, the economics team from investment manager Payden and Rygel said that the US bond market typically existed in two states — the Federal Reserve was either in hiking or cutting mode.
However, the economists proposed the US bond market - one of the deepest and broadest fixed income markets in the world - was now potentially in a “third state” of “being on hold”.
According to estimated from the Bank for International Securities, the US has the largest bond market in the world, valued at over $51trn, and managers and investors are watching the Fed to see what it does next to tackle "sticky" inflation.
Expectations have flipped trying to second-guess when central banks would pivot away from hikes and take a more dovish stance.Jason Hollands, Evelyn “We don’t see any signs of alarm in the labour market, and the data still points to an economy that will grow by 2.6 per cent in Q4 — far above trend,” Payden & Rygel said.
“So where does that leave us? While our base case is still a soft landing, where the Fed is on hold and not cutting, we want to highlight the risk of the second-most likely scenario: a no-landing.
“In this scenario, growth remains above trend, but inflation is too sticky for the Fed’s liking. After a pause, the Fed might be raising rates again, and we do not think investors are considering this risk — much less pricing it in.”
Peak rates?
Bonds have come back in favour recently, especially for new investors. Yields have shot up recently, and experts say that across the board, fixed income is now an attractive sector.
As central banks hint that they are reaching the peak of interest rates — both the Bank of England and the Federal Reserve held interest rates at the last meeting — bonds may become more attractive.
One disadvantage of fixed income is that if interest rates move higher, the yield offered on your bond will be lower than the market rate (and so the price will fall, pushing up the yield to match the new, higher rate). But if rates are likely to be steady or even move lower over the next year, there is less risk of this.
Jason Hollands, from wealth manager Evelyn Partners, said: “Market expectations have flipped around this year trying to second guess when central banks would pivot away from hikes and take a more dovish stance.
“The new guessing game is how long rates will remain at current levels. It really comes down to a combination in taming inflation, which remains a work in progress, and whether economies will achieve a so-called ‘soft landing’ or dip into recession.”
In recent weeks, both the Bank of England and the Federal Reserve have clearly endeavoured to reinforce the message that rates could stay elevated for a while yet.
The returns you get from bonds look enticing today.Ben Yearsley, Shore Financial PlanningThe UK was potentially likely to see interest rate cuts a little quicker than the US, according to Lindsay James, investment strategist at Quilter.
This is because the “interest rate transmission” from the central bank to consumers is arguably more potent in the UK, due to the fact fixed-term mortgages are far shorter than in the US.
James said: “The UK economy is going to be hard-pressed to grow in 2024 as a further tranche of home loans come up for renewal, pushing up average monthly payments by hundreds of pounds.
“The Bank of England will be under increasing pressure in 2024, an election year, to respond to the weakening economy.”
Other experts have encouraged investors to forget about the outlook for rates and to take advantage of the high yields on offer at the moment. The US 10-year Treasury yields nearly 5 per cent and the 10-year gilt pays about 4.5 per cent.
“I look at the bond markets and don’t worry too much about the wider issues — just at what the potential returns might be,” said Ben Yearsley, investment director at Shore Financial Planning.
“And I think the returns you get from bonds look enticing today. You can get more than 6 per cent from high quality bonds, what’s not to like about that?”
Imogen Tew is a freelance financial journalist
