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This week’s rally in global bond markets has shattered investors’ months-long assumption that interest rates in the US and elsewhere will remain higher for longer.
The benchmark 10-year US Treasury yield, seen as a proxy for borrowing costs around the world, fell below 4 per cent for the first time since August. The policy-sensitive two-year yield, which closely tracks rate expectations, slipped to its lowest point since May.
Other government bond markets have also undergone a dramatic about-turn in recent days, with Germany’s 10-year Bund yield sliding to its lowest level in nine months as its price shot higher.
The sharp moves came after the Federal Reserve gave its clearest indication yet that it would not raise borrowing costs again, and signalled that it expected three quarter-point cuts in 2024. Fed chair Jay Powell noted that the benchmark rate was “likely at or near its peak for this tightening cycle”.
“Higher for longer is dead,” said Kristina Hooper, chief global markets strategist at Invesco. “Powell wrote the epitaph [this week].”
As recently as early November, markets had been bracing for an extended period of elevated borrowing costs as central banks continued their battle to tame inflation.
In recent weeks, signs of a cooling economy and softer price growth data had helped to ease those concerns — lifting bond and stock markets. But the Fed’s closely watched “dot plot” projections on Wednesday were seen by many as the most official sign yet that “higher for longer” was over.
By Friday, markets were reflecting investors’ expectations of six US interest rate cuts in 2024 — beginning as soon as March. Those predictions would take borrowing costs in the world’s biggest economy from a current range of 5.25 to 5.5 per cent down to roughly 3.9 per cent.
“A dovish pivot from the Fed is a full-speed ahead signal for the bond market,” said Bob Michele, chief investment officer and head of the global fixed income, currency and commodities group at JPMorgan Asset Management.
While New York Fed president John Williams said on Friday that talk of rate cuts as soon as March was “premature”, his note of caution was not enough to halt the rally.
The upbeat narrative also persisted in Europe and the UK — where inflation has been far more stubborn than in the US — even as European Central Bank president Christine Lagarde and Bank of England governor Andrew Bailey pushed back against the prospect of imminent rate cuts.
Buoyant investor sentiment also lifted stock markets this week, with Wall Street’s S&P 500 closing out its seventh straight week of gains and edging closer to a fresh record high.
Some strategists noted that US inflation was still far from the Fed’s long-term target of 2 per cent — meaning that rates are unlikely to come down rapidly. The US headline consumer price index reading for November came in at 3.1 per cent — down from October’s figure of 3.2 per cent, and in line with consensus forecasts.
But for Michael Kushma, chief investment officer of broad markets fixed income at Morgan Stanley, “the Fed has switched its focus from inflation to growth”.
If the Fed is satisfied with waiting for price growth to return to 2 per cent, he added, “there’s no reason to have too weak an economy in 2024. The Fed has decided that inflation is behaving, so off to the races we go”.
The sharp drop in government bond yields this week has also translated into much lower debt funding costs for corporate borrowers. The average bond yield for junk-rated US companies has fallen to less than 8 per cent, according to an Ice BofA index, around levels last seen in February — with Thursday marking its biggest daily drop in 13 months.
The spread or premium paid by risky borrowers over the US government also narrowed by a sizeable 0.33 percentage points on Thursday to 3.47 percentage points.
Concerns have intensified this year that some of the lowest-rated companies on both sides of the Atlantic will struggle to refinance their debt in an environment of much higher funding costs, potentially sparking an uptick in defaults. Junk-rated US companies alone are staring down a $1.87tn maturity wall over the next five years, according to Moody’s.
But “even though we haven’t seen one rate cut yet . . . There has been a significant easing in financial conditions that is giving companies breathing room,” said Invesco’s Hooper.
The prospect of cuts has more pronounced implications for floating-rate loan issuers than for fixed-coupon bond issuers, said Andrzej Skiba, head of Bluebay US fixed income at RBC Gam.
“Unlike in US high-yield bonds where it’s a marginal positive, in the leveraged loan space and private credit [space], it could make the difference between a company getting into trouble and not.”
Still, he noted that a further slowing of the US economy could start to weigh on corporate profits.