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Accept Decline
by  S.Cheah, MBA, CFA, J.Lee, CFA Oct 1, 2024

Central bankers around the world are finally lowering policy rates, pushing down bond yields and buoying fixed-income returns. New Zealand became the sixth G10 country to start easing monetary policy in early August, and we expect the U.S. to finally follow suit when the Federal Reserve meets in September. Investors are anticipating deep interest-rate cuts from policymakers over the next two years. We think that investors expect too many cuts, absent a recession. We forecast mid-single-digit returns for global government bonds over the next 12 months.

After hiking interest rates aggressively over the past couple of years, policymakers are now easing policy. In most economies, inflation has fallen back to within striking distance of 2 percent (Exhibit 1). With inflation closer to target, central bankers can support economic growth and employment by cutting interest rates. The sharp slowdown in inflation and rising unemployment rates suggest that policy has started restricting economic growth. Some easing of policy over the next year makes sense.

Exhibit 1: Inflation is very close to 2%

National or regional inflation rates, adjusted for methodological differences
Exhibit 1: Inflation is very close to 2% <h5>National or regional inflation rates, adjusted for methodological differences</h5>

Note: As of July 2024. Source: National statistical agencies, RBC GAM calculations

Of course, the decline in bond yields over the past several months already reflects expectations for interest-rate cuts. In Canada, the U.S., the UK and the eurozone, investors expect policy rates to fall about 2 percentage points from their peak over the next two years, much of it front-loaded (Exhibit 2).

Exhibit 2: Expected drop in policy rates from their respective peaks over the next two years

Exhibit 2: Expected drop in policy rates from their respective peaks over the next two years

Note: As of August 28, 2024. Source: Bloomberg, RBC GAM calculations

We are confident that short-term interest rates in these markets will be lower over the next year for two reasons. The first is that even the more restrictive (or “hawkish”) models for central-bank policy suggest that interest rates should be cut. For another, most central banks have already started cutting and one cut usually precedes a series of reductions.

At the same time, most economies, and particularly the U.S., are more likely to grow than contract over the next year. While the risk of recession is higher than usual due to the currently restrictive stance of monetary policy, a recession is still not our base case. Absent a recession, current expectations for deep interest-rate cuts are unlikely to be met. Long-term bonds already offer lower yields than short-term Treasury bills and cash, and without even-lower expectations for policy rates, we believe bond returns will have a tough time beating those offered by cash.

In addition, bond returns could suffer over the next 12 months if growth proves to be more resilient than expected and inflation more stubborn. We believe inflation is a particularly acute risk for bonds. Even though inflation is running at a roughly 2% pace, the composition of price changes is far from normal. Prices typically rise for both goods and services, with each contributing about equally to 2% rises in prices across the economy. Prices for goods are falling, which is unusual. Meanwhile, prices for services are still rising by 4% to 5% per year (Exhibit 3), well above their pre-pandemic pace and at a rate not consistent with 2% inflation over the long term.

Exhibit 3: Both goods and services inflation is very unusual

Exhibit 3: Both goods and services inflation is very unusual

Note: As of April 2024. Source: National statistical agencies, RBC GAM

The post-pandemic spike in price pressures has also left a mark on consumers’ psyches. While the median consumer expects inflation to average just over 2% over the long term, a large share of consumers now expects very high inflation (Exhibit 4). This change in expectations is likely to wear off only after a prolonged period of low and stable inflation.

The increased sensitivity of consumers and businesses to price changes means that central banks are likely to respond aggressively to any re-acceleration in inflation. Moreover, they would have to do so regardless of the source of increase in price pressures. Prior to the pandemic, central bankers often insisted on looking past inflation caused by rises in food and energy prices – so-called transitory sources of inflation. We think they would be remiss to rely on this logic with the memory of the rapid rise in prices so fresh in mind.

Exhibit 4: U.S. consumer inflation expectations are less anchored than they appear

Expected annual change in prices over the next 5 years
Exhibit 4: U.S. consumer inflation expectations are less anchored than they appear <h5>Expected annual change in prices over the next 5 years</h5>

Note: As of July 2024. Source: University of Michigan

As mentioned in recent editions of the Global Investment Outlook, we are very concerned about the state of public finances. The increase in fiscal spending due to the pandemic has been only partially rolled back, and governments are running remarkably large deficits. While governments in Europe are taking early steps to correct fiscal imbalances, many others, the U.S. in particular, are not. Investors can be fickle in extending their confidence to government debts. What’s more, they seem to have become pickier: in 2022, gilt investors effectively toppled the nascent government of Liz Truss, and in France, snap elections this summer prompted a surge in the government’s borrowing costs. While the timing of a reckoning is uncertain, we think that more spendthrift governments are increasingly at risk of paying much more to borrow. Some of our concerns relate to the parlous state of government finances, but also reflect the fact that interest rates are now much higher.

Over the next 12 months, we expect bonds to deliver returns roughly equal to their current yields.

Direction of rates

United States

As we expected, inflation has cooled in the world’s largest economy and the U.S. Federal Reserve (Fed) is now widely anticipated to cut interest rates in September. Alongside slower price rises, the labour market has softened. The U.S. unemployment rate rose to 4.3% in July, nearly a full percentage point higher than the 3.4% low reached in January 2023. More significantly, the rise in the rate of joblessness has triggered the so-called “Sahm rule,” which has historically coincided with the U.S. already being in or imminently being in a recession. Heightened concerns over the prospects for growth mean that investors have built up large expectations for future interest-rate cuts. We think that concerns about growth are overblown. The U.S. economy is expected to grow at a 2%-plus pace in the third quarter – a relatively robust outturn. Moreover, the labour market is likely stronger than indicated by the rise in the unemployment rate. The number of people losing their jobs due to layoffs is extremely low, and almost all of the rise can be attributed to a growing pool of workers looking for employment. From an economic point of view, this is much less serious than rising layoffs and will probably help lower pressure on employers to raise wages, slowing price rises.

We expect the Fed to reduce the target range for the fed funds rate to between 4.00% and 4.25% over the next 12 months. The market expects even deeper cuts to between 3.25% and 3.50%. We think such deep cuts are unlikely without a sharper downturn in economic activity. For U.S. 10-year bonds, we expect yields to be unchanged a year from now at 3.75%.

Eurozone

The European Central Bank (ECB) cut rates in June, lowering the key policy rate to 3.75% from 4.00%, and we expect the policy rate will be lowered again at the ECB’s September meeting. The rate should drop to 2.50% over the next year as inflation cools and economic growth remains relatively sluggish.

Europe has enjoyed a fillip to growth due to strong government spending, but the spending has raised acute fiscal concerns for the single-currency area. France’s creditworthiness was questioned in the run-up to surprise parliamentary elections earlier in the summer. While those concerns have eased, France now pays more to issue debt relative to safe-haven Germany than was the case before the election. The jump in borrowing costs for a core member of the eurozone raises the risk that more spendthrift members of the eurozone such as Italy could face similar or even more damaging increases in borrowing costs. For now, investor confidence in national governments appears stable in the most trouble-prone members, and the European Commission’s recent initiatives to curtail excessive fiscal spending are welcome.

Against a backdrop of fiscal restraint, slowing inflation and weaker economic activity, we would normally expect bond yields to fall. However, market pricing indicates that investors already expect rate cuts to happen faster than we do, and German bunds offer very low yields relative to cash – giving investors little incentive to lend for longer. We forecast the 10-year bund yield to be 2.35% in a year, compared with 2.30% now.

Japan

The Bank of Japan (BOJ) hiked interest rates for the second time this year at its July meeting, bring the policy rate to 0.25%. While we expected interest rates to keep rising gradually in Japan, the move appears to have caught many investors off-guard, as the hike prompted a surge in the value of the Japanese yen and a 12% one-day collapse in the value of Japanese equities. These moves proved to be relatively short-lived, but perhaps presage concerns that many investors have about Japan’s ability to exit a prolonged period of extremely low policy rates. The BOJ’s policy rate is barely above zero, but at the same time is higher than it has been since 2007. According to market expectations and our own forecasts, policy rates will rise to their highest level since the mid-1990s over the next 12 months.

To be sure, inflation is also as high as it has been since the 1990s. Moreover, price pressures appear stickier than previous cases when inflation rose to 2% or more. In those instances, faster inflation was primarily due to one-off tax hikes or concentrated in goods most exposed to yen weakness. In the current environment, price pressures are present throughout the Japanese economy and are evident in large wage increases. We think policymakers are likely to continue tightening over the next year, raising the policy rate to 0.75%. Japanese bond yields should also continue rising, with the 10-year bond yield reaching 1.50% over the next 12 months from 0.90% at the time of writing.

Canada

With inflation pressures fading and economic growth softening, the Bank of Canada (BOC) began easing monetary policy in June and has delivered three consecutive cuts of 25 basis points since then. Inflation slowed to 2.5% annually in July, the lowest rate in over three years. Policymakers also appear more confident that inflation is making a sustainable return toward the 2% target. The BOC is focusing on supporting labour markets as the unemployment rate has climbed from a low of 5.0% in September 2022 to 6.6% in August 2024. While policymakers are concerned about the possibility of rate cuts reigniting the housing market, they are more worried that the economy is likely to remain weak in the months ahead.

With a goal of avoiding further weakness in the economy, we expect the BOC’s monetary-policy easing will continue amid higher unemployment and sluggish economic growth. Our base case forecast is that the policy rate will fall to 3.25% over the next 12 months (from 4.25% after its September meeting) and that the Canadian 10-year government bond will be trading at 3.25% within that time frame from around 3.00% at the time of writing.

United Kingdom

The Bank of England (BOE) eased monetary policy in August, cutting the benchmark interest rate to 5.00% from 5.25%. The BOE’s governor provided no guidance on further easing. Persistently high inflation for services and better-than-expected economic activity mean that while we expect the BOE to eventually continue easing policy, it will be at a relatively modest pace. We expect a further 75 basis points of cuts from the BOE, leaving rates at 4.25% a year from now. Meanwhile, investors are wary of the new government’s inaugural budget, which is due at the end of October and promises to promote economic growth without hiking income taxes. A too-large loosening of the fiscal purse strings risks strangling the progress made tying down inflation pressures and reintroducing concerns about the UK’s fiscal situation.

At the time of writing, investors are expecting the BOE’s policy rate to drop to 3.80% in a year. We expect less easing from the BOE than the market. In turn, we are expecting 10-year gilt yields to rise to 4.25%, up slightly from 3.91% at the time of writing.

Regional recommendation

Continued policy tightening in Japan means we expect the poorest returns for investors in this region. Meanwhile, reasonable starting yields around 4% and interest-rate cuts should see the U.S. bond market outperform. We recommend being 2.5% overweight U.S. Treasurys and 2.5% underweight Japanese government bonds.

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