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Rates likely to be range-bound after the rally

05 July 2019

By Michel Vernier, CFA, Head of Fixed Income Strategy

A football manager’s decisions are often wrong in the eyes of the supporters. And when the team is not successful, the president of the club usually joins in. Sounds all too familiar to Jerome Powell, chair of the US Federal Reserve (Fed) who is facing criticism from some market participants and the US president alike.

Fed signals a move

In its June meeting the Fed has indicated that rate cuts are very likely. Markets quickly priced in a 100% chance of a 25 basis point (bps) rate cut in July which we agree with.

Markets quickly priced in a 100% chance of a 25 basis point rate cut in July.

After last month’s aggressive moves in the rate markets, it is hard to keep up. Is the yield curve still inverted or flat? Which part of the curve is inverted? How does it compare with other bond markets? The graph below illustrates recent developments in the EUR, GBP and USD sovereign curves.

Flattening yield curves

US yield curve to steepen at short end

While the US sovereign curve was already flat at the beginning of the year, the market started to price in several rate cuts which has led to an inversion in the six month to the 2 and 3-year part of the curve. This has led to a slight steepening between the 10 and 2-year section of the curve. It is likely that the overall curve will soon start to steepen slightly for two reasons.

Firstly, lower Fed policy rates will resolve the inversion at the short end of the curve while rates in the longer end only have limited downside potential, at least in the medium term. Secondly, the overbought situation in the US long end of the bond market makes rates vulnerable to some retracement. In the long term, rates will closely watch the lower trending inflation expectations. This could keep yields at lower levels for some time.

The economic data does not clearly point to a recession in the short term, which would be needed to warrant another leg down in the long end of the curve. A neutral positioning is justified in our view.

Further flattening seems likely, suggesting deeper negative yields at the long end.

European yields to stay low for longer

In Europe, the central bank’s more dovish policy language last month indicates that yields will stay low for longer amid a weaker growth outlook for the region, trade uncertainties and lower trending inflation expectations.

Unsurprisingly, longer tenors started to price in the policy shift, leading to a flattening of the curve, while the longer end (illustrated by the French sovereign curve) is still relatively steep. Given the potential effects of the trade tensions to Europe’s core economies, Italian political uncertainty and weaker inflation expectations, a further flattening seems likely, suggesting deeper negative yields at the long end.

Higher UK interest rates look unlikely

The Bank of England (BOE) still tries to put the case forward that gradual rate hikes are likely once Brexit is resolved, justifying this with the excess demand in the UK economy. We expect the market to price out any possibility of rate hikes very soon. The economic data does not seem to support the BOE’s ambition. Meanwhile, increased Brexit uncertainty will result in further pressure on the UK economy.

Investment grade bonds of longer duration offer a moderate carry and enhanced yield while providing a hedge should the UK economy deteriorate.

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Market Perspectives July 2019

Find out our latest key investment themes. As more dovish central banks and trade tensions drive sentiment, what are prospects for the rest of 2019?

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