The sell-off in government debt and surge in yields since mid-September has been driven by market concerns about the sustainability of national fiscal positions. Investors are hoping for interest rate cuts to drive investment and a re-rating of equity valuations, but a bonds reset at decades-high yields could provide an attractive opening to consider certain shares.
Analysts at UBS argued in a recent note that UK yields are too high in a “now clearly oversold market”. They view the current moment as a buying opportunity for utilities, such as SSE (SSE) and National Grid (NG), and “very cheap” real estate stocks.
In the UK, the yield on 10-year gilts surpassed 4.8 per cent earlier this month, the highest level since 2008, and the spread against German bonds is the highest since 1990. The yield on US 10-year Treasuries also hit a 17-year high, other than a spike in 2023.
Much commentary has been about apparently elevated yields. But perhaps investors should view current figures as a reversion to the long-term trend after two decades of abnormal lows, with rates approaching their terminal point? The terminal rate can be thought of as the neutral policy rate, which hypothetically supports stable inflation and full employment, the endpoint of an easing cycle.
That’s the position of Berenberg chief economist Holger Schmieding, who argues that yields are now close to where they should be given his take on long-run fundamentals. He forecasts the 10-year gilt yield will rise to 4.7 per cent this year, and the 10-year Treasury yield will hit 4.9 per cent. UBS, on the other hand, expects the gilt and Treasury yields to fall to 4.1 per cent and 4.25 per cent, respectively.
Investors, Schmieding said, “should embrace the return to the old normal of yields” after “the unusually low and flat levels of the last 20 years”. It is worth noting his position that “countries with high debt levels, a rapid rise in the ratio of debt to GDP and a history of policy mistakes (think post-Brexit and post-Liz Truss UK) are at particular risk” from a normalisation of yields.
Schmieding expects inflation to remain sticky and that central banks will have to accept price rises remaining above targets for the foreseeable future. That’s because of various factors, including wage rises (a long-run consequence of rock bottom birth rates), the passing on of those costs to customers, and threats to free trade. In this context, he doesn’t expect any more rate cuts by the Fed this cycle and has pencilled in two 25 basis points cut by the Bank of England.
That is out of line with market projections. The FactSet consensus is for the Federal Reserve to serve up rate cuts worth 75 basis points this year, and the Bank of England to cut by 100 basis points. The market expects 10-year yields to sit at 4.34 per cent in the US and 4.22 per cent in the UK by the end of 2025.
But expectations have moved in Schmieding’s direction. Traders, per the CME FedWatch tool, think there is a 99.5 per cent chance that rates will be held by the Fed next week. They took completely the opposite view a month ago.
When it comes to bonds and the outlook for yields, Axa Investment Managers chief investment officer for core investments Chris Iggo thinks its time for income-hungry investors to get into the asset class. Given concentration risks and valuations, he argued “there is limited scope for global investors to add more to their US equity holdings”, although cautioned that higher inflation poses a risk.
Investor takeaways are clear: don’t be surprised if rate cuts don’t materialise, and there is even potential for rate rises. With new US president Trump setting out an inflationary agenda, though the extent of tariffs remains to be seen, investors should prepare for volatility and keep in mind some historical perspective on yields.
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