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Volatility in fixed income

03 October 2022

Bond market turmoil is shaking equity markets as investors assess the future path of growth and inflation. Simple stories of a slowdown that might lead central banks to ease aggressively supporting an eventual economic rebound are fading from memory. What once was the willingness to position for the end of 2023 and beyond, benefiting Growth stocks, has shortened to a view of the next few months and the need for risk management. The latest surprising source of risk comes from the bond market and particularly British Gilts.

What happened in the UK Gilt market?

In the UK, the proposed large expansion in the government’s budget through unfunded tax cuts has shaken confidence in Gilts and the Pound (GBPUSD). Ten-year Gilts, which had been rising for weeks, increased by 40 basis points on the budget announcement as the Pound plunged sharply lower. Analysts including the IMF decried the UK’s move which forced the Bank of England to buy long-dated Gilts under pressure from large investors and eventually the government to partially back down. The Debt to GDP ratio standing at 97% might increase to more concerning levels.

What does it mean for European bonds?

The fear is that contagion from one bond market hits others as investors as investors lose confidence in their ability to anticipate the terminal rate of this rate hiking cycle from the Fed to the ECB. Indeed, inflation in the Eurozone in September was higher than expected at 10% with core rising more than expected at 4.8%. The temptation is still to position for the eventual cycle of rate cut, but as we have seen it is dangerous to go in too early.

What does it mean?

We continue to prefer the safety of short-duration Covered Bonds. Eventually, the virtuous circle of risk taking in fixed income will start as expectations of fading inflation firms up. For High yield, we also need to be able to decently forecast the bottom of the business cycle and consequent default rate – we are not there yet. Expectations regarding the mixture of growth & inflation are likely to oscillate a lot for a few more months until monetary policy has a significant impact. In such an environment, choosing investment grade companies with a resilient business model that are not too expensive continues to make sense.

 

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