Global government-bond yields have risen since the last edition of the Global Investment Outlook, reflecting tempered investor expectations for central banks to cut interest rates. In the U.S., too-high inflation has been more persistent than expected and economic growth in the first half of 2024 better than forecast. Because of rising yields, government bonds in all major markets have posted losses so far this year (Exhibit 1).

Exhibit 1: Global government bonds have had a poor start to 2024

Year-to-date returns for select government-bond markets

Note: As of May 31, 2024. All returns are expressed in currency-hedged terms to Canadian dollars. Source: FTSE Russsell

Does this portend another year of negative total returns for bonds? We don’t believe so. Some of this year’s poor performance is due to timing: Bond yields fell sharply just before the turn of the year and have since risen. Since last October, when yields reached multi-year highs, bonds have recorded positive returns as yields are now lower. Higher and more volatile yields mean simply that bond returns have become more variable than investors have grown accustomed to since the financial crisis. However, higher yields also provide investors with higher expected bond returns. Over the long run, a bond’s current yield to maturity is a good guide for future returns (Exhibit 2), so investors can expect returns of around 4.50% per year on the U.S. 10-year government bond if held to maturity. Over the next 12 months, we forecast that bond returns will likely be better than that as we expect most central banks to cut interest rates.

Exhibit 2: U.S. 10-year Treasury note and returns

Note: As of May 31, 2024. Source: Deutsche Bank, Macrobond, RBC GAM

Policymakers in Europe and Canada have delivered their first interest-rate cut this cycle while those in the UK should follow suit before the end of the summer. The U.S. Federal Reserve (Fed) is likely to start lowering rates a little bit later, probably in the fall. Lower inflation means that policymakers can shift their focus toward supporting growth and labour markets, which have softened everywhere. This means rate cuts.

Policymakers tentatively admit that interest rates have likely peaked but are reluctant to endorse the suggestion that substantial easing of monetary policy is in the offing, which would be a boon for bond returns. For their part, investors expect central bankers to deliver between 75 and 125 basis points of cuts over the next year in Canada, Europe, the U.S. and the UK. Such decreases appear paltry compared with the several hundred basis points of rate hikes delivered over the past several years. Policy rates priced in forward markets two and three years from today are still well above those that prevailed before the pandemic. Measured against estimates of so-called neutral rates (the rate of interest at which monetary policy neither stimulates nor restricts growth), it appears that investors expect monetary policy will remain in restrictive territory for the next decade.

In effect, market expectations imply that there is no risk of recession or need for easy monetary policy over the next 10 years. This seems unlikely. We can agree that the immediate risk of recession has receded. RBC GAM no longer expects a recession in the U.S. over the next year, and in the near term it doesn’t appear that most economies need substantial help from monetary policy. While inflation has fallen precipitously, it remains above target in all regions even after accounting for methodological differences (Exhibit 3). Unemployment has risen, but from levels that were probably too low to be sustained without generating yet more inflation. Over the course of a decade, however, it is almost certain that many economies will experience at least one recession and that central bankers will cut rates more than currently expected. To us, this makes bonds attractive.

Exhibit 3: Global inflation remains above target everywhere except Canada

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

High expectations for policy rates through the long term could also be explained by the idea that perhaps the interest rates that economies would find restrictive have risen since the pandemic. Higher government deficits and greater investment needs to battle climate change – alongside the higher debt-servicing costs that accompany those burdens - can slow rather than accelerate growth. We are not as convinced about higher neutral fed funds rates as the market appears to be. We are more convinced that the market should price in a larger premium to lend over long time frames - the so-called term premium. Over time, we expect the U.S. Treasury yield curve to steepen, with 10-year securities offering investors higher yields than 2-year bonds, something that hasn’t happened since July 2022.

We think that with inflation having slowed at the fastest pace in three decades and unemployment rising, central bankers can conclude that current policy rates are indeed restrictive. As inflation falls further, we think most central banks will provide some cuts to markets, pushing down bond yields, particularly on bonds maturing over the next two to three years.

The fly in the ointment for this story of restrictive interest rates, falling inflation and coming rate cuts is the relative success of the U.S. economy in shrugging off sharply higher rates. Policymaking at the national level does not happen in a vacuum. The recent stickiness of price pressures and above-trend growth in the U.S. reduces the confidence of other central bankers that price pressures in their own economies have abated more quickly due to policy or simply reflect the waning impact of pandemic-related supply shortages. What is more, growth has been picking up in Europe, which has experienced particularly sluggish activity, and this trend may obviate the need for sharp interest-rate cuts to support the economy.

To be sure, we don’t anticipate a return to the pre-COVID period of exceptionally low interest rates. What we do expect is a return to more normal conditions, even without a recession. Inflation closer to policymakers’ targets and rising unemployment suggest that at least some monetary accommodation is appropriate.

We think most central banks will ease policy as the year progresses. Disinflation should continue in most countries and, after surprisingly high U.S. inflation to start the year, inflation has started easing again in the U.S.

Direction of rates

United States

The U.S. economy posted another period of decent growth through the first three months of the year. Worryingly, inflation also picked up much more than expected. To be sure, we expect inflation to cool over the balance of 2024 and into 2025 given our view that the current stance of monetary policy is restrictive. While not our base case over the next 12 months, rising unemployment and cooling demand raise the odds of a recession. Against this backdrop, we expect the Fed to ease policy from current levels. Our base case forecast is that the target range for the fed funds rate will decline over the next 12 months to between 4.50% and 4.75% from the current 5.25% to 5.50%, with cuts beginning in the second half of 2024. We expect that Treasury yields will be broadly unchanged, with the 10-year bond yield trading around the current 4.50% level over the next year.

Eurozone

The eurozone economy, in contrast to the U.S., continues to exhibit disinflation as the transitory effects from the pandemic and the rise in oil and natural-gas prices due to the war in Ukraine fade. Economic growth has been weak, suggesting that monetary policy is tight. Inflation has now slowed more than in the U.S., leading the European Central Bank (ECB) to lower its policy rate 25 basis points on June 6, the ECB’s first cut since September 2019.

The case for easier monetary policy is stronger in Europe considering the starkly different backdrop for public spending. Unlike in the U.S., the fiscal largesse that has bolstered growth, particularly in Italy and Spain, is likely to subside sharply this year. Several nations are likely to be hemmed in by the EU’s requirements that members maintain fiscal discipline, possibly leading to persistent fiscal headwinds over several years, barring a recession and subsequent loosening of restrictions on government spending.

Wage growth in Europe remains too high to generate inflation at 2% or below when measured versus a year ago but is slowing measurably. We think that inflation has likely slowed enough for the ECB to confidently lower policy rates. Wage demands seem to be easing alongside inflation. Ultimately, we think a cooling economy and slowing inflation will encourage the ECB to continue cutting rates – with the deposit rate falling from 3.75% now to 2.50% in a year’s time. German 10-year government bond yields already reflect much of the expected decline in policy rates, and we expect them to be just slightly lower in a year, at 2.40%.

Japan

Bond yields in Japan continue to rise, reflecting expectations that policy rates will climb. The 10-year government-bond yield rose above the key psychological level of 1.00% in late May and we think further increases are likely over the next year. Japan is experiencing a profound increase in realized and expected inflation that it has not experienced since the 1990s. Even with a relatively weak economy, Japanese workers are enjoying the strongest wage growth in the G7 group of developed nations.

The Bank of Japan (BOJ) has signalled its intention to raise interest rates by permitting government bond yields to rise. The BOJ’s policy rate should rise above zero for the first time since 2016. We forecast the benchmark interest rate at 0.20% in a year’s time. Meanwhile, we expect bond yields to rise, with the yield on the 10-year Japanese government bond reaching 1.25% in the year ahead.

Canada

On June 5, the Bank of Canada (BOC) dropped its policy rate for the first time since the pandemic, a 25-basis-point reduction to 4.75%. The move by the central bank reflected a greater degree of comfort that core inflation is waning. Consumer inflation has slowed for four straight months, with annual inflation easing to a three-year low of 2.7% in April, and the BOC’s preferred three-month annualized measures (so-called CPI-median and CPI-trimmed) of core inflation dropped to 1.5% and 1.8%, respectively, below the 2% target. These inflation statistics point to rate cuts starting this summer.  The BOC expects to continue shrinking its balance sheet - a process known as quantitative tightening (QT) - into 2025 (versus previous guidance of late 2024 or early 2025) and to continue with QT.

We expect policy rates in Canada to come down faster than they will in the U.S., where growth and inflation are stronger. The two central banks have been as much as 100 basis points apart on policy rates since 2000, compared with the current spread of about 60 basis points. 

The BOC’s pivot to monetary-policy easing would probably be gradual given the risk of stoking another bout of faster-than-target inflation. We expect the BOC policy rate will fall to 4.00% over the next 12 months, and that the Canadian 10-year government bond will yield 3.50%, down from 3.63% at the time of writing.

United Kingdom

The UK labour market continues to show signs of weakness. Job vacancies are coming down swiftly, and wage growth is expected to slow from the current high level. Softening wage growth, especially in services, is expected to help reduce inflation, taking the edge off an area that has been keeping the inflation rate above the Bank of England’s (BOE) target. The BOE’s rate-setting monetary-policy committee recently telegraphed that lower rates are coming when it reduced its forecast for intermediate-term inflation and said the risk of persistent inflation is declining. As the first rate cut approaches, the debate will shift to the speed and size of rate cuts, exerting downward pressure on gilt yields. However, as Britons go to the polls in July, the next government faces a challenge related to its fiscal position, ultimately raising questions about the sustainability of the country’s debt. A lack of attention to fiscal discipline could prompt bond investors to demand higher yields as compensation for factors including slowing growth, deteriorating public services, falling living standards, high debt-servicing costs and a poor historical record of controlling inflation. We pencil in four BOE cuts over the next 12 months to 4.25% from 5.25% and expect 10-year bonds to trade around ranges observed in recent months, with a forecast of 4.10%.

Regional recommendations

We have no regional recommendations this quarter. The global rise in interest rates and prospect of policy rate cuts has increased the attractiveness of bonds. We recommend being overweight fixed income.