Analysis-Bonds back in a tailspin as ‘higher for longer’ narrative hits By Reuters

By Yoruk Bahceli and Dhara Ranasinghe

(Reuters) – Government bond markets from Europe to the United States and Australia are in a tailspin as the prospect of higher interest rates sparks a rout in longer-dated bonds, hurting investors seeking higher returns after a lacklustre first half.

German and British two-year borrowing costs touched their highest levels since 2008 this week, U.S. peers have hit highs not seen since 2007, and Australia’s bond yields rose to decade highs.

The latest drubbing in the world’s biggest bond markets, which last year suffered a record rout, does not yet point to any dysfunction in the markets themselves, investors said.

But in echoes of the volatile conditions seen during March’s banking crisis, trading in euro zone benchmark German government bond futures were briefly interrupted on Thursday when bond yields spiked.

Investors took hawkish U.S. Federal Reserve June meeting minutes, strong U.S. services sector data and private payrolls numbers as signs that the Fed — and other central banks — may have to keep rates higher for longer. Weaker-than-expected non-farm payrolls data did little to change the mood on Friday.

“Markets are saying that inflation is too high, and growth is still too strong, and we need more rate hikes,” said Mike Riddell, senior portfolio manager at Allianz (ETR:) Global Investors.

“Central banks seem to be encouraging markets to believe this too, suggesting more hikes are ahead.”

Prospects for a November Fed hike also rose in addition to a July move, and traders have further reduced the rate cuts they priced in for 2024, with bets nearing the Fed projections traders had initially shrugged off in June.

In Europe, they anticipate the Bank of England may have to hike rates to 6.5% by December, adding one more increase to their expectations since last week. And traders now see a small probability that European Central Bank rates will peak at 4.25%, not the 4% they expected previously.

HIGHER FOR LONGER

Crucially, while the recent yield jump had been driven by shorter-dated bonds, longer-dated bond yields are now leading the push higher.

That’s a sign that investors are reconsidering what “higher for longer” rates means for longer-term borrowing costs, said Nordea chief analyst Jan von Gerich.

Market reaction to Friday’s more closely watched employment data was limited, and bond yields across the board were set to end the week higher.

Germany’s 10-year yield, which staged its biggest daily jump since March on Thursday, was eyeing its biggest weekly jump since last September, up 25 bps. Bund futures on Thursday posted the biggest volume yet seen for the September contract, IFR analysts said.

U.S. and British 10-year yields were also set to end the week more than 20 bps higher.

As longer-dated borrowing costs rose faster than shorter ones, the closely watched U.S. yield curve measured by the gap between two- and 10-year Treasury yields was set to end the week steeper for the first time since early May.

It was at minus 91 bps, having flattened to minus 109.5 bps earlier this week in the biggest inversion since 1981.

    “With long-dated bonds the issue is that yield curves have become so inverted it becomes hard to like long-term bonds unless you can convince yourself that rates will come down in your investment horizon,” said Mark Dowding, chief investment officer at BlueBay Asset Management, who holds a neutral position on U.S. and euro zone bonds.

In Germany, the 10-year yield rising above 2.5% marked a “significant development”, said Gael Fichan, head of fixed income at Syz Group, noting that was a level that had acted as resistance preventing higher yields in the shorter run.

Analysts noted 5% on two-year and 4% on 10-year Treasuries — levels breached on Thursday — as other key milestones.

“It is crucial to recognise that the repricing in the 7-10 year sector, where long positions are concentrated, is particularly susceptible to a stronger and sustained higher for longer narrative, potentially leading to losses,” Fichan said.

No doubt, the renewed selloff throws a curve ball at bond investors, who have been disappointed so far after last year’s record 13% losses.

The hope was for better returns in the second half of 2023, but global government bonds lost 1% this week, cutting this year’s returns to a meagre 0.7%. Global equities, while down 1% this week, are still up 11% this year.

“There is a concern that if data remains strong, if central banks need to keep going further, then we are going to see a redux of 2022,” BlueBay’s Dowding said.

“It won’t be as bad as that, but higher rates and higher yields could lead to negative returns and pressure returns on equity markets.”