As interest rates start to fall, government bonds will provide attractive returns.

Over the past three years, we have witnessed significant volatility in bond prices as central banks flooded the global economy with cash to pay for a Covid recovery. The peak of the loose monetary policy saw US$11tn of sovereign debt trading at negative interest rates. As interest rates increased to counter the resulting inflation, yields rose and prices fell. Long dated government bonds loosing up to a quarter of their capital value.

With inflation having peaked and now falling, interest rates too are likely to have peaked. With the decline in both inflation and interest rates then the benchmark US 10-year treasury yields are likely to ease also. They peaked at a sixteen year high of 4.97% on 19th October and now stand at 4.47%. This decline in yield is a confidence measure. The fall in yields has also resulted in a rise in prices. Bonds values are now recovering the losses made when yields were higher. Many leading bond fund managers think that bond yields have risen to their peak.

High yields are the cost of borrowing. This has risen across the world with governments and corporations challenged by higher refinancing costs. Governments do not want high interest rates as borrowing costs and the servicing of debt hits public spending. The world could not handle bond yields over 5% very well. The Bank of International Settlements warn of the implications of such yields will have on margin calls for derivative contracts.

While inflation has been the focus for many months, the focus has now shifted to the slowing economy as a slowing economy with high interest rates is not ideal. PMI indicators are generally hovering around 50 points showing a weak outlook for economic activity.

The pausing of interest rates by three major central banks in the first week of November is a measure that policy makers are concerned. It feels that inflation has been restrained and it is all about keeping inflation under control while not hurting the economy.

This does seem to have happened in the US as GDP growth for Q3 was 4.9% up from 2.1% in Q2, indicating that the US has beaten inflation and grown their economy at the same time. Commentators put much of this growth down to the massive infrastructure spending and Green Deal that pushed investment and raised the supply side of the US economy. It also pushed US government debt to 129% of GDP, and increase from 107% when Joe Biden took office.

We have been maintaining an overweight position in short dated credit including some floating rates. This is in addition to the hedged bond and target return bond funds we have held. As there is now a point of pivot in interest rates and yield, we are increasing our longer dated government bonds. There is an expectation that as interest rates start to fall then government bonds and investment grade bonds will provide attractive returns.

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