By Yoruk Bahceli
(Reuters) – Public borrowing costs in developed economies saw their sharpest rise in several months in April, evidence that bond markets are not yet out of the woods when it comes to inflation and the threat of interest rates. interest higher than expected for longer.
U.S. inflation, which rose the most in six months, pushed two-year Treasury yields above 5% in April as traders reduced bets the Federal Reserve would cut rates.
Benchmark U.S. 10-year yields, up more than 40 basis points (bps) to 4.6%, their biggest rise since September when fiscal concerns grew, could also soon reach 5%, estimate some investors. Bond yields move inversely to prices.
In Europe, German 10-year bond yields crossed the closely watched technical level of 2.5%. Britain rose almost 40 basis points, its biggest monthly rise since May.
Ed Hutchings, head of rates at Aviva Investors, said without cooling US economic data it was difficult to bet with conviction that bond yields would fall.
“Until the data changes, investors will want a little extra compensation for holding government bonds,” he said.
Hutchings favored shorter-term eurozone and UK debt over Treasuries, but noted that US yields had pulled European peers higher.
Global government bonds have lost 2.5% for investors since the start of the year. That risks leaving the modest 2023 return as a failure after losses of 15% over 2021-2022, when the sharp rise in inflation surprised markets and policymakers.
The latest developments highlight the market’s sensitivity to inflation, even if it slows from double-digit levels in 2022.
EUROPE TOO
Traders also limited their expectations for European rate cuts, adding to the sell-off in bonds.
They expect cuts of just 40 basis points from the Bank of England this year, down from around 70 basis points at the end of March, and around 70 basis points from the European Central Bank , compared to 90 basis points at the beginning of April.
Although the Fed’s revised rate cut forecasts drove much of the moves, investors also reacted to data this month showing that UK inflation and wage growth slowed less than expected . Dovish remarks, followed by hawkish comments from BoE policymakers, have also changed expectations.
At the same time, economic activity in Britain and the eurozone grew more than expected, at the fastest pace in almost a year, reflecting a strengthening of economies, also confirmed by a growth stronger than expected in the euro zone in the first quarter.
“You need to have a high degree of conviction in your models that, in an environment of slowing inflation and strong economic activity, inflation will not start to rise again,” said Piet Christiansen, chief analyst at Danske Bank.
Many investors favor euro zone bonds, which have outperformed as inflation approaches the ECB’s 2% target, paving the way for expected rate cuts in June.
Data released Tuesday showed inflation at 2.4% in April, as expected. The closely watched measure of services slowed for the first time in months, even though core inflation fell less than expected.
Yet ECB policymakers have been cautious about cuts beyond June.
“The (activity) data coming in calls into question how many rate cuts are needed after the June cut,” Christiansen said.
Another sign of caution, the euro zone inflation expectations indicator monitored by the ECB reached its highest level since December at around 2.4%, while oil prices increased.
The outlook for UK debt is more uncertain. A Reuters poll of economists expects the BoE to cut rates by 75 basis points by the end of the year, almost double what markets are expecting.
If BoE traders’ expectations rise, this would favor UK debt. Goldman Sachs recommends buying 30-year government securities rather than Treasuries.
But high funding needs would limit the fall in longer-term bond yields, Imogen Bachra, head of non-dollar rates strategy at NatWest Markets, said in a note Monday, although she expects a fall of 100 basis points this year.
Gilts have underperformed global government bonds even as inflation slows, losing investors more than 4% year to date.
ARE BONDS STILL RETURNING?
To be sure, investors say bonds remain attractive given the attractive returns they offer long-term holders after spending a decade at or below 0%.
Case in point: Britain saw the third highest level of demand on record for a 30-year bond selling at a record yield.
Some investors said their dampening impact on the economy would limit future rises in U.S. bond yields, which determine other borrowing costs.
“I suspect that just as investors were too complacent a few months ago on inflation and rates, the opposite is true now and we will see bond yields moderate somewhat,” said Guy Miller, strategist Chief Market Officer of the Zurich Insurance Group.
Economic uncertainty in the United States is expected to keep global markets volatile.
“The market is coming up with a probability-weighted outcome: no cuts, some cuts, and perhaps a very small tail of additional cuts in the future,” said Idanna Appio, fund manager at First Eagle Asset Management and former Fed economist.
(Reporting by Yoruk Bahceli; additional reporting by Dhara Ranasinghe; editing by Emelia Sithole-Matarise)
