Bond markets are facing a reckoning after a stellar summer

(Reuters) — Government bond markets, which have enjoyed a summer of solid price gains, are now facing their bets on rapid central bank rate cuts and slowing inflation, not to mention a tight presidential election in US.

Benchmark 10-year US Treasury yields ( ^TNX ) are set to end August down nearly 30 bps, their biggest monthly decline this year, driven by expectations for faster rate cuts even as economic data eased recession fears sparked by recent US. job report.

With borrowing costs in Germany and the UK posting big falls in July, all three regions were already set for their first quarterly declines since the end of 2023. Bond yields move inversely with prices.

For some, these moves confirm one of today’s big investing themes — the idea that “bonds are back” after taking a beating amid a post-pandemic surge in inflation and interest rates.

Government bonds returned just 4% globally last year, after losses of 15% in 2021-2022, and are back 1.3% year to date.

However, large investors believe that gains will at best be lost or at worst turn out to be exaggerated.

“We have many indicators that show the economy is not entering a recession. We are just in a soft landing,” said Guillaume Rigeade, co-head of fixed income at Carmignac.

“It’s not justified for us, this acceleration to such a rapid cut cycle,” said Rigeade, who is bearish on longer-dated bonds on both sides of the Atlantic.

Bonds were boosted by bets that the Federal Reserve will cut interest rates by about 100 basis points in its three remaining meetings this year — a move of 50 bps — double the level expected at the end of July. Traders also increased bets on peers such as the European Central Bank.

However, the message appears to be at odds with equity markets, whose rout has left yields flat since mid-July, while global government bonds have returned about 2%.

Economists polled by Reuters also expect about one less move than traders anticipate from the ECB and the Fed this year.

The discrepancies highlight the challenge of navigating the government bond market for the rest of 2024 for investors looking to make meaningful returns.

Testing time

The first test comes in the form of next week’s US jobs report in August.

If it shows a second month of significant weakness, it could increase bets on a 50 bps Fed move in September, while stronger printing may undercut the price of cuts, analysts said.

“We’re at the slowdown point in the economic cycle … It’s where you get the most volatility in terms of data like wages,” said Guy Stear, head of developed markets strategy at research arm Amundi Investment Institute. of the largest company in Europe. asset manager.

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He recommends assessing how much of the fall-summer bond yields hold in early September before adjusting positioning.

Bond markets were also supported by easing inflation. Market indicators of inflation expectations recently fell to a three-year low in the US and a nearly two-year low in the euro zone.

While headline numbers are moving closer to the central bank’s targets, core inflation remains stickier on both sides of the Atlantic, warranting caution.

“The market is too optimistic in the way it prices a perfect normalization,” Carmignac’s Rigeade said, adding that the risks are tilted towards higher-than-expected inflation in the coming quarters.

Although limited, the rise in oil prices driven by tensions in Libya and the Middle East in recent sessions is a sign of uncertainty ahead.

November puzzle

Undoubtedly, the elephant in the room remains the US presidential election in November.

The race between Vice President Kamala Harris and Republican rival Donald Trump is tight, and 61 percent of investors in an August BofA survey were still not trading the U.S. Treasury election.

“Whatever the outcome, it will result in still high fiscal spending and a large supply of US Treasuries,” Capital Group chief investment officer Flavio Carpenzano said.

A Trump presidency backed by a Republican Congress would put pressure on longer-dated bonds in particular, involving both higher spending and inflation that risks staying above the Fed’s 2 percent target, Carpenzano added.

The focus on fiscal discipline, along with more clarity on US growth, could support eurozone bonds, which outperformed last year but underperformed US peers this year.

The U.S. economy grew faster than expected in the second quarter, and economists polled by Reuters upgraded their full-year growth expectations to 2.5 percent.

They still forecast growth of 0.7% this year in the euro zone, which grew by just 0.3% in the last quarter, while Germany unexpectedly contracted.

“If there’s an economy that needs proper tapering (interest rate cuts), it’s the eurozone, because that’s where the fundamentals are weaker and deteriorating,” said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International .

(Reporting by Yoruk Bahceli; Editing by Dhara Ranasinghe and Hugh Lawson)