Government bonds fell during the third quarter due to worries about the economy and an extended period of high interest rates, and some investors anticipate further declines.

Fund managers who were hoping for relief from the historic losses bonds suffered in 2022, when the U.S. Federal Reserve and other central banks raised interest rates to contain surging inflation, were disappointed to learn that U.S. and German government bond yields were set to end September with their biggest quarterly rises in a year.

Bond yields, which move in the opposite direction of prices, appeared to be peaking earlier this year, but recent hawkishness from central banks has sent them skyrocketing once more.

For instance, benchmark 10-year Treasury rates in the United States are currently around 4.55%, which is close to 16-year highs. Some investors believe they could increase to 5%, a level last seen in 2007. According to Bank of America Global Research, Treasuries are on course to record their third consecutive annual loss, a circumstance unheard of in American history.

Equities are expected to experience their first quarterly decline this year in both the U.S. and Europe as a result of the increase in rates. Global currencies are in a tailspin as the U.S. dollar surges, with U.S. Treasury yields leading the increase.

“The bias is finally being absorbed by the marketplace that rates will remain higher for longer,” said Greg Peters, co-chief investment officer at PGIM Fixed Income.

The Fed’s aggressive rate estimates from last week, which show borrowing costs continuing at current levels for much of 2024, startled markets and have been a major motivator.

Investors had to quickly adjust; traders now predict that the Fed’s policy rate, which is now at 5.25%–5.50%, will decrease to 4.8% by the end of 2024, a significant increase from the 4.3% they predicted at the end of August.

Similar to how markets have delayed expecting rate cuts from the European Central Bank, policymakers have held to their call for higher rates to last longer. Money market pricing indicates that traders anticipate the ECB’s deposit rate to increase to approximately 3.5% by the end of 2024 from approximately 3.25% at the end of August.

According to Kit Juckes, global head of currency strategy at Societe Generale, hawkish central banks have lessened the appeal of longer-dated bonds, which despite yield curves being inverted continue to offer investors lower yields than shorter-dated ones. Kit Juckes also noted that the pressure on bond markets was due to the U.S.’s high funding needs.

He stated, “It just seems as though finding enough buyers for all the Treasuries is requiring a painful price discovery process.”

Investors claimed that additional factors that have emerged in recent weeks are also influencing prices.

One of them is the U.S.’s economic situation, where the budget deficit has increased and a credit downgrade by the ratings agency Fitch has alarmed some investors. The Fed is also moving forward with “quantitative tightening” at the same time, which is a reversal of the enormous central bank bond purchases made to bolster markets in 2020.

Because of this, “yields will rise until investors believe that longer-dated bonds are compensating them for the supply that we know is coming,” according to Mike Riddell, senior portfolio manager at Allianz Global Investors.

Another significant risk that might keep pressure on inflation and, consequently, bond yields is the surge in oil prices, which are already close to $100 per barrel and up 28% so far this quarter.

This quarter has seen a nearly 76 basis point increase in yields on the benchmark 10-year Treasury, which is on pace to be the biggest quarterly increase since last year.

The benchmark 10-year yield for the euro zone, which is set by Germany, has increased 52 basis points to 2.9%, the largest quarterly increase in a year.

Italy’s 10-year rates have increased by 75 basis points this month, and the debt market continued to plunge on Thursday as the government raised its deficit targets and lowered growth projections.

The increase in yields has impacted stocks as well as bond investors, giving equities investment competition and rising borrowing costs for businesses and individuals.

Despite being up 11.3% year-to-date, the S&P 500 index is down 3.4% this quarter and on course for its worst decline in a year. In contrast, the Stoxx 600 index for Europe has gained 5.6% this year but fallen 2.9% in the past three months.

Investors have begun reevaluating the potential for extremely high yields. “Sticky” inflation, according to strategists at BofA Global Research, may push the US 10-year yield to 5%. ING also predicted that the German 10-year yield might reach 3%.

The rapid rise in yields has “overshot where fundamentals should be and put us in highly speculative territory right now,” according to Ed Al-Hussainy, senior interest rate analyst at Columbia Threadneedle Investments, who thinks there is a “high probability” that yields will reach 5%.

Despite the turmoil, some investors still see opportunities.

At CNBC’s Delivering Alpha conference on Thursday, Rick Rieder, chief investment officer of global fixed income at BlackRock, stated that he favours shorter-dated bonds as well as the belly of the yield curve and has been purchasing commercial paper.

When investors have a better understanding of the Fed’s monetary policy trajectory in December, according to Noah Wise, portfolio manager at Allspring Investments, rates will decline.

“When investors see the Fed is likely to stay on the sidelines, that will be a less frightening market to get involved in,” he said.

(Adapted from StraitsTimes.com)

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