Central Bank Policy and Global Bond Yields

SUMMARY

• In Europe, the ECB is stimulating a sluggish economy…
• …while in the UK, the problem is inflation.
• In contrast, the US is responding to stronger growth.
• Thus, we believe the Fed will be ‘slower to lower’ rates.

Central banks around the world have begun recalibrating their monetary policies now that inflation has subsided. Since June, the world has seen the Federal Reserve (Fed) and the Bank of England (BOE) cut twice, while the European Central Bank (ECB) cut its policy rate three times to remove restrictive monetary parameters. On the other end of the spectrum, the Bank of Japan (BOJ) has hiked interest rates twice in 2024, as their economy has experienced sustained inflation for the first time in decades. The impact of each central bank’s decision has played out in the global bond markets.

The Fed May Be ‘Slower to Lower’

The Fed made an aggressive 50-basis point rate cut to kick-off its rate cutting campaign in September, followed by a 25-basis point cut at its November meeting. Financial strategists anticipate the Fed will cut again in December, and then lower the fed fund funds rate by an additional 1% in 2025. If this projection is correct, the fed funds rate would end 2025 at 3.375%, in line with the Fed’s forecast from September.

However, the economy is not cooling as fast as many forecasters have predicted. In Q3, GDP grew at 2.8% after growing 3% in Q2. To put this into perspective, the US economy is growing as fast as it grew the quarter prior to the pandemic, when the fed funds rate was at zero. Furthermore, inflation has slowed, and the labor market has been resilient, despite hurricanes and strikes making the data harder to analyze over shorter periods of time. Accordingly, the ‘data-dependent’ Fed looked beyond the volatility in the employment numbers at its most recent meeting by stating that “the risks to achieving its employment and inflation goals are roughly in balance.” Hence, we believe that the Fed may be “slower to lower” interest rates than the market is predicting. For proof, just look to the 10-year Treasury for guidance.

The Rise in Treasury Yields Point to Higher Growth, not Inflation

Prior to the Fed’s September rate cut, the 10-year Treasury yielded 3.62%. However, as of November 15th, the yield had moved up to 4.44%. As we wrote in our September 24th Weekly View, we expected 10-year yields to stall as the yield curve normalizes. At first glance, this market reaction defies logic because the Fed lowered short-term rates to help stimulate the economy. However, for simplicity’s sake, if we break the 10-year nominal yield into its’ two main signaling components, one can better understand the market reaction post-rate cuts.

In our chart below, we show 3 things. The blue line is the yield on 10-year Treasury notes. The green line is the yield on Treasury Inflation Protected Securities or TIPS. It shows the real yield, or the portion of the nominal yield, (blue line), that is the expected inflation adjusted return for investing in the bond. The pink line is the difference between the green and blue lines. It represents the market’s implied inflation expectations and is known as the ‘break-even’ yield.

After the first rate cut, the economic data has improved as the labor market has firmed, which in turn pointed to the economy growing. As you can see in the chart, inflation expectations (pink line) have been relatively stable over the last month as real yields have risen (green line). Thus, we believe nominal bond yields are reacting more to an improvement in US growth prospects than an acceleration of inflation risks. With growth prospects rising, the Fed may be ‘slower to lower’ interest rates than the market is pricing, in our view.

International Central Banks: Customized Responses for Different Economic Conditions

Internationally, the Bank of England (BOE) and the European Central Bank (ECB) both have begun cutting their policy rates as well. Unlike the Fed, the BOE and ECB have opted to only move in 25-basis point increments. Thus far, the BOE has seen its 10-year Gilt react very similarly to the 10-year Treasury with yields 0.59% higher since the rate cuts began. The 10-year Gilt yielded 3.88% in August when the BOE first cut and now yields 4.47% after the second rate cut. Unlike in the US, where rising rates reflect better economic prospects, the Gilt market views the rate cuts as increasing the likelihood for inflation to reappear. The ECB on the other hand has cut three times, and 10-year Bunds yield 2.35%, 0.20% lower than when the central bank began cutting in June. The ECB rate cutting policy has lowered yields due to the eurozone economy being in a more tenuous state, as its largest economy, Germany, attempts to avoid a recession. Thus, it is evident not all central bank easing policies are created equal. On the other end of the spectrum, the BOJ has raised interest rates as inflation expectations have increased. However, unlike the other developed central banks, its benchmark 10-year is rangebound.

Conclusion: We Continue to Prefer US Treasuries and the US Dollar over International Bonds

While we still prefer domestic equities over bonds in our balanced portfolios, we believe that US Treasuries are a better relative value than international bonds for our fixed income allocation due to the relative yield differential. Even in the case of 10-year Gilts where yields are comparable to Treasuries, we do not see the risk-reward benefit given the added currency risk that comes along with such an allocation. We expect more money to flow into Treasuries as investors are getting a second chance to get off the sidelines and lock in higher yields for longer, as the Fed will be slower to lower, in our opinion. Additionally, the market reaction to the Fed’s rate cutting campaign has strengthened the dollar as the US is seen as having the best economic prospects relative to other developed economies. We believe higher yields on Treasuries will bring more investors to the table, both foreign and domestic, which should enhance the dollar’s appreciation.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.