2023 has been an(other) extraordinary year in fixed income markets. Contrary to many peoples’ expectation that the interest rate cycle would peak as inflation rolled over, rates have stayed stubbornly high in developed markets.

The case for a recession being on the horizon may appear overwhelming, and yet strategists and market participants have been constantly surprised this year as growth remains robust globally, and in particular in the US. What may break us out of this pattern?
Are we nearly there yet?
Central bank governors in developed markets have been very clear in their guidance over the last few months that they are reaching the peak of their interest rate cycles and that any future action is going to be driven by what they see in the data. In my view it would take quite a significant upward surprise in growth for them to change that stance.

When you’re running a macro-orientated investment process, you naturally try to look at what the current macro regime is, then examine forward-looking data and anticipate inflection points that may cause the macro regime to shift so that your portfolio can be positioned appropriately. Those leading indicators have been ‘flashing red’ and suggesting a recession (indeed a hard and prolonged recession) for some time … yet when the hard economic data prints come out they broadly tell a story of an economy that’s holding up. This divergence has only become more pronounced.
Is it inevitable that yield curves will steepen?
If you look away from the US at the other developed market economies, we are starting to see more signs of weakness. I’ve recently been looking in particular at the UK, where the unemployment rate ticked up to 4.2% and the net employment change for Q2 was expected to be positive but actually surprised to the downside and came in negative. This could foreshadow similar weakness in other developed markets going forwards.

I have been of the view that a hard economic landing was the most likely outcome. However, any sensible investor must take into account the reality of recent economic data being strong – as such I think the scenario of rates staying higher for longer should have a greater probability attached to it. The implication of that is that yield curves in developed markets should arguably be a lot steeper than they are today.

Being actively positioned for a steeper yield curve is, in my view, almost a win-win scenario for sovereign bond investors like myself. If rates stay higher for longer then the rate cuts that are currently priced in, will have to be priced out again which would result in a steeper curve. However, if the hard landing does transpire and rates need to be cut aggressively then the front end of the curve will come down and also contribute to a steepening of the yield curve.

In general there is a lot of yield to be harvested across that investment universe at the moment, with yields in the high single digits possible in an average of A-rated securities. This all adds up to what I think is an exciting time to be an active investor in global sovereign bonds.
The value of active minds – independent thinking
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