The rise in bond yields leads to new opportunities for investors

Laurent Denize – Global Co-CIO ODDO BHF                            Prof. Dr. Jan Viebig – Global Co-CIO ODDO BHF 

What caused the increase in yields?

Yields on Treasury bonds have reached a new high in more than a decade. Borrowing costs for U.S. 10-year government bonds have surged from 3.7 percent in mid-July to over 4.8 percent this week. 10-year yields in Germany surged from 2.2 percent to 2.9 percent and in Italy from 4.0 percent to 4.9 percent over the same period. There are several reasons explaining the recent increase in yields: central bank policies, economic growth and strong labor markets, inflation expectations, and term premia.

1. Central bank policies: On September 20, 2023, the Fed did not raise interest rates but made crystal clear that rates will most likely stay higher for longer:“… the most important question at this point is not whether an additional rate increase is needed this year or not, but rather how long we will need to hold rates at a sufficiently restrictive level to achieve our goals …” (Fed Vice Chair for Supervision Michael Barr). Christine Lagarde also argued that interest rates will stay high “as long as necessary” to fight inflation. Market participants are now realizing that interest rates will most likely remain “higher for longer” which drives borrowing costs even higher.

2. Economic growth and strong labor markets:  The economic resilience and the persistent strength in the labor market are another reason for the increase in yields. Nonfarm payrolls in the U.S. increased by 336,000 jobs last month, much stronger than expected. The U.S. economy is too resilient 18 months after the Fed started to increase interest rates. The time-lag between the first interest rate hike and a slow-down in the economy is usually between 12 and 18 months. It seems that the economies both in the U.S. and in Europe adjust this time much slower to rising interest rates which supports the higher for longer narrative. As economic growth is still strong and labor markets tight, central banks have to keep interest rates high to cool down demand for goods and services which will cause inflation to fall.

3. Inflation expectations : Inflation expectations are an important driver for future inflation rates. In a recent study, Albrizio and Bluedorn (2023) argue that inflation in advanced economies surges by 0.8 percentage points for each 1 percentage point increase in near-term expectations.

Forward inflation rates are now higher than average historical inflation expectations both over the near-term and the long-term. While headline inflation rates are coming down, core inflation – which excludes the more volatile prices on food and energy – is still more than twice as high as the 2% inflation target of the ECB and the Fed. The surge in inflation expectations is one of several factors that bond yields are now at 16-year highs.

4. Term premia : Investors ask for a compensation for bearing the risk that interest rates may change over the life of a bond. This compensation is referred to as “term premium”. The term premium for 10-year treasuries has increased not only as investors assume that central banks will keep interest rates higher for longer but also as governments announced that they will issue more debt to finance growing deficits. The dysfunctional debate in the U.S. over congressional spending and a possible default does not increase investor confidence. But the U.S. is not the only sinner. While the debt-to GDP-ratio in Italy already exceeds 140 percent, Giorgia Meloni’s government has recently hiked its deficit targets. The increase in deficit targets threatens Italy’s credit rating. As the scrutiny of rating agencies increases, the gap between the yields of Italian and German yields widened. If investors fear that countries may default or try to inflate away debt, governments have to pay investors higher yields to attract capital flows to finance the growing debt burden. Investors already started to demand a higher premium for holding longer-term maturity bonds as a compensation for increased risks.

What are the investment implications of the rise in bonds yields?

No Need to Hurry

A smooth landing of the economy is crucial to repositioning towards risky