The bond market’s volatile year continues in earnest. Over the past quarter, investors raised their estimates for central-bank policy rates in response to stronger-than-expected economic activity, mostly in the U.S., and still-elevated inflation. Investors are also demanding higher compensation to hold long-term bonds - a surcharge popularly referred to as the term premium – in part due to concerns about the poor state of government finances. A rising term premium and expectations for higher policy rates pushed the U.S. 10-year Treasury bond’s yield to 5.02% on October 23, the highest since July 2007. As a result, investors in U.S. government bonds are flirting with an unprecedented third consecutive calendar year of losses (Exhibit 1), which would be disappointing given the low single-digit returns we had forecast a year ago.
Exhibit 1: Investors might face a 3rd straight year of losses
U.S. government-bond returns
Note:Data as of December 5, 2023. Source: RBC GAM, Bloomberg Barclays
We think that investor expectations for higher yields are misplaced. Much of the world economy continues to slow, weighed down by the lagged effects of an aggressive global monetary-tightening cycle. Since the third quarter of 2022, most major economies have barely grown at all (Exhibit 2) and look likely to slow further in the year ahead. The factors that have buoyed growth in the U.S., where the economy expanded by a vigorous 4.9% annualized rate between June and September, also do not appear repeatable. So, while most forecasters have withdrawn their recession forecasts over the past six months (Exhibit 3), we have increased our odds for an economic contraction.
Exhibit 2: Most countries have been growing very slowly
Economic growth since September 2022 after removing inflation
Source: RBC GAM, National statistical offices
The U.S. economy looks particularly vulnerable to a slowdown. The factors that contributed to the remarkable growth over the past 12 months - fiscal largesse, households’ pandemic savings and ample banking-system liquidity - look unlikely to be repeated. Increased scrutiny of government finances and a sharply divided Congress mean we expect a modest drag from government spending over the next year. Pandemic savings also seem to be exhausted, removing an important source of consumer-spending power. Finally, liquidity in the U.S. banking system was much more ample over the past year than expected – providing a fillip to the economy. Over the next 12 months, we expect tighter monetary policy to weigh more heavily on activity as the U.S. Federal Reserve (Fed) continues to reduce its balance sheet.
In addition to a slowing economy, we think bond returns will be supported by better valuations. The latest rise in yields, driven by higher expectations for central-bank policy rates and larger term premiums, has improved valuations considerably. Real (inflation-adjusted) yields have climbed sharply, term premiums are as large as they’ve been in 10 years, and inflation compensation is at cyclical highs. In our view, investor expectations for these factors affecting bond yields are now too high.
Policy-rate expectations are considerably above what we would consider appropriate over the long term. Bond-market pricing suggests the fed funds rate will stay close to 4.00% for the next 10 years. Expectations for European policy rates are similarly lofty at nearly 3.00%. In both markets, market pricing for policy rates far exceeds estimates of neutral policy rates (the rate that neither stimulates nor dampens economic growth) and does not entertain the possibility of a serious recession over the next decade.
Exhibit 3: Odds of a U.S. recession have fallen
Median probability of a recession over the next year
Note: Data as of December 5, 2023. Source: RBC GAM, Bloomberg
We think real yields at current levels offer a compelling investment case for bonds. The real yield on a 10-year inflation-protected security in the U.S. is 2.5%, compared with the Congressional Budget Office’s estimate of potential real GDP growth of 1.8%. Real interest rates look even more egregiously high versus projected labour-force growth, which sits at just 0.4%. Labour-force growth is a “hard-data” version of potential GDP, since all the workers who will enter the labour force over the next 10 years have already been born.
Bonds, in our view, are offering investors more than fair compensation through today’s higher term premiums, which are consistent with historical relationships such as volatility implied by options on interest rates. We expect volatility in the bond market to eventually decline, and the term premium should fall as well.
Compared to the rise in policy-rate expectations and the term premium, inflation expectations have risen only modestly. We think this is because central banks have shown a credible commitment to keeping inflation close to 2%. We expect inflation to continue to gradually fall over the next 12 months – closer to 2% over time. There are arguments that inflation might trend higher over the long term – in part due to climate change, deglobalization, rising wages, and consumer expectations for higher prices. But those considerations should be accompanied by the admission that bond yields already imply an attractive compensation for inflation of nearly 3% over the longer term.
In this environment, what kind of returns should bond investors expect? For the year ahead, we expect mid-to-high single-digit returns, with decent odds of a low double-digit return in some markets. Part of this higher-return expectation is explained by higher starting yields. If bond yields are unchanged a year from now, a starting assumption for an investor in U.S. government bonds would be a 5% return. This starting yield is itself generous, but also acts as a buffer against further yield increases and as a springboard for returns should yields decline as we expect. For example, if the yield on the U.S. 10-year Treasury bond were to rise by 100 basis points over the next year, investors would show a loss of 2.3%. If yields fell by the same amount, the total return would be 13%.
For most of the past year our positive call on bonds has rested mostly on a view that a markedly slowing economy would lead to lower bond yields. But the past quarter’s move higher in bond yields has also improved valuations, further supporting the case for bonds. To be sure, our belief that a recession likely looms has become more open to challenge. Most forecasters have spent the past few months ratcheting down their odds of a U.S. recession over the next 12 months, and the consensus is for no recession. Our view remains the opposite: we expect a recession and, given the passage of time since the beginning of the hiking cycle, the chances of a recession have risen. In our view, this bolsters the return potential for government bonds.
To our mind, the major risks to the bond market lie with inflation and government deficits. While investors' concerns about runaway inflation have largely abated, and inflation expectations remain within historical norms, the risk is that inflation stalls in the 3%-4% range. We believe that wages remain the biggest risk to central banks achieving their inflation targets. Moreover, we believe a recession is probably necessary to slow wage gains in a timely manner. Absent a continued slowdown in price pressures, the environment would be ripe for most central banks to resume their hiking cycles, and for bond investors to drive yields even higher. This is the type of inflation environment that drives our thinking on realistic “worst-case” scenarios for bonds.
Exhibit 4: Current market yields are far above government payments due on coupons
Note: Data as of: December 5, 2023. For all publicly-held bonds and bills. Par-weighted coupon – for bills, market yields were used. Source: RBC GAM, Bank of America
Fiscal and bond-supply concerns are also on our radar. The budget situation in most major Western countries is poor, and governments will be issuing substantial amounts of debt under current spending and revenue projections. What is peculiar about the run-up in borrowing is that it is occurring outside of an economic downturn. Moreover, market yields are now much higher than existing coupon payments, meaning that governments face rising interest costs as existing debt reaches maturity and is replaced with new, higher-cost debt. (Exhibit 4). As a result, interest costs will continue to rise over time even if there is no increase in the amount of debt outstanding. In some countries, this rise in borrowing costs will start to hit quite quickly. In the U.S. and Canada, nearly 50% of currently outstanding government debt will reset to higher rates by the end of 2025 (Exhibit 5). For now, we think these rises are manageable. The U.S. debt-to-GDP ratio will rise without significant changes to spending or taxation, but the situation is much different than that faced by the eurozone’s weaker economies such as Italy and Greece in the early 2010s. These countries had deep-rooted structural growth problems that preceded concerns about debt sustainability – a factor that does not affect the U.S.
Exhibit 5: Governments need to renew lots of debt before January 1, 2026
Share of outstanding bonds and bills maturing within 2 years
Note: Data as of December 5, 2023. Source: RBC GAM, Bank of America
Direction of ratesUnited States
The Fed raised its target range for the fed funds rate to 5.25% to 5.50% in July, after keeping rates on hold in June. This Fed’s move was in line with our view based on still too-high inflation and a too-tight labour market. We expect just one more hike from policymakers in the current cycle, likely in November. The fall in inflation, despite a remarkably resilient pace of economic growth, means that the risk of tightening too much is now higher. While falling inflation likely removes the need for much further tightening, resilient growth means that the Fed is likely to keep rates at high levels into the middle of next year before the start of rate cuts. At the time of writing, long-term bond yields in the U.S. were rising quickly, reflecting concerns about the poor fiscal outlook in the U.S.
As mentioned above, while the long-run fiscal outlook is poor, we think that the U.S. government has substantial room to raise revenues through tax hikes. Policymakers could, of course, decide to shrink spending back to a level more consistent with pre-pandemic levels. Whenever these adjustments occur, they are likely to depress growth in the short to medium term, pushing down yields and pushing up bond prices. We expect the fed funds rate target to be between 4.50% and 4.75% in a year’s time and the yield on the 10-year U.S. Treasury to fall to 3.50% from about 4.30% now.
Eurozone
The European Central Bank (ECB) hiked interest rates by 0.25% at both its June and July meetings to bring the deposit rate to 3.75%. Strong demand for European government debt, especially that of fiscally weaker countries such as Italy, has kept policymakers focused on containing inflation. Inflation remains much too high, but disinflation seems to have taken hold in most of the single-currency area. It appears that the current hiking cycle in Europe might come to an end much sooner than most investors were expecting.
As recently as May, investors thought that long-run policy rates in Europe might rise as high as those in the U.S. We did not think this scenario would play out, as Europe’s potential for economic growth is likely much lower than the U.S. and the region requires lower central-bank policy rates as a result. The European economy is also more sensitive to rising borrowing costs than America’s, leading us to believe that the economic slowdown might happen faster and be more pronounced. Over the past six months, the German economy has been weak, posting two consecutive quarters of contraction. Manufacturing activity is also remarkably weak, partly reflecting the lack of a hoped-for rebound in Chinese growth, and services activity now appears vulnerable to a slowdown as well. Moreover, fears that high unionization rates in Europe would stoke inflation through big wage deals appear to have been unfounded.
We expect the ECB will hike just once more to 4.00%, before cutting rates back to 3.25% starting around the middle of next year. Against this backdrop, we expect yields on 10-year German government bonds to reach 2.60%.
Japan
The Bank of Japan (BOJ) surprised markets by tightening monetary policy at its July meeting, in line with our expectations for an eventual unwinding of the central bank’s exceptionally easy policy stance. Unlike its developed-market peers, which have tightened their policy stances at the most aggressive pace in decades, the BOJ, until July, had refrained from making any material tightening. Also unlike its peers, inflation in Japan has not slowed. In response to the highest and longest period of sustained inflation since the 1990s, inflation expectations are climbing quickly, raising the risk that price rises could become entrenched at a higher rate than the BOJ wants
The changes to the BOJ’s yield-curve control policy, which for the past eight years has kept the gap between short- and long-term rates in a tight range, could have large spillover effects on global bond markets. These adjustments have allowed Japanese interest rates to rise, making overseas bonds less attractive to Japanese investors and potentially removing a large and important buyer of global bonds. Truth be told, Japanese investors had been large sellers of foreign bonds for some time due to punitive currency-hedging costs and a realization that Japanese interest rates couldn’t stay near zero forever. We expect further tightening of monetary policy over the next year, with the overnight rate rising above 0% for the first time since 2016, to 0.10%. The yield on the 10-year Japanese government bond should also rise, to about 0.75%, from 0.60% at the time of writing.
Canada
After pausing rate hikes for five months, the Bank of Canada (BOC) resumed benchmark increases in June and July, lifting the policy rate to 5% for the first time since 2001. Strong demand and sticky inflation, due in large part to strong population growth, prompted the decision. The BOC does not expect inflation to return to its 2% target until mid-2025, about two quarters later than the bank forecast in April. Immigration, strong labour markets and household savings accumulated during the pandemic continue to underpin strong demand and are helping to offset higher inflation and mortgage rates. That said, consumer spending is drifting lower as debt-servicing costs climb and that trend will continue and even accelerate. Tight credit conditions and prospects for slower economic growth are starting to dent business investment. We forecast that the policy rate will remain at 5.0% for the rest of 2023. In 2024, we expect the BOC will cut the policy rate to 4.25% by the fall. We expect the Canadian 10-year government bond will yield 3.00% sometime over the next 12 months.
U.K.
We expect the Bank of England (the BOE) to halt policy tightening before the end of this year, with rates peaking at 5.75%. In the coming months, policymakers will shift their attention beyond the peak in rates, and we expect the BOE to cut rates in 2024 as household finances deteriorate due to higher interest costs and slowing economic activity. As the renewal pace of fixed-rate mortgages picks up, household consumption is likely to slow. The impact of higher mortgage rates on borrowers will be dramatic, and some Britons renewing a 25-year mortgage could face a 50% increase in monthly payments. As weak as we expect economic activity to be, inflation remains above the BOE’s target, and this fact will tend to underpin rates and keep the BOE from supporting real activity as much as it would like.
The path toward lower yields faces a large hurdle given investors’ concern over the credibility of the U.K. Treasury. The government’s deteriorating finances and the probability of rising issuance in the coming months may lead investors to demand higher yield premiums. Debt-servicing costs currently stand at 4% of GDP, double the level in 2020 and the highest in 20 years. The surge is particularly large due to inflation compensation paid on government debt whose payments are linked to changes in prices. This issue is particular to the U.K., as a large percentage of the country’s government debt is tied to such changes. We expect the U.K. benchmark interest rate to fall to 5.25% sometime over the next 12 months and the yield on the 10-year gilt to drop to 4.25%.
Regional outlook
Reflecting greater economic resilience in the U.S. relative to the rest of the world, we recommend being underweight Treasuries and overweight German bunds.
Discover more insights from this quarter's Global Investment Outlook.
