What could be next for US and UK government bonds?

The recent flash market crash saw a rally in government bonds. This could have been triggered by several things, including a softening in the US labour market, fears that the Federal Reserve (the Fed) is behind the curve, a rate hike from the Bank of Japan (BoJ) or mega-cap earnings disappointment.

Either way, it reinforced the strategic value of holding fixed income in a portfolio as concerns about economic growth have generated significant returns for the asset class in the short term.

But what could be next for the asset class and where should investors allocate across the yield curve?

The returns data detailed in this article are based on one-year capital market assumption models to create a customised one-year forward yield curve.

This is based on one-year forward-looking expectations for central bank policy rates, inflation, two-year government bond yields, and the shape of the curve.

These scenarios aren’t designed to gauge an exact view on where future yields will end up. But to show a range of outcomes under different circumstances, which could impact bonds of different duration and country allocations.

All data and scenario assumptions are as of 06/08/2024

Base case scenario

United States

Our base case scenario assumes that US inflation continues to moderate –albeit at a slower place – with some inflationary pressures persisting in areas, particularly the services sector.

We expect the Fed to cut interest rates three times over the course of the next year. This is less than the current market expectations.

Based on this assumption, we expect the yield curve to reprice higher in the short-term following the recent market rally in rates, which we believe is an over-reaction.

Given the recent market rally in US treasuries, under our base case scenario, we would expect a slight shift upwards in the yield curve, which would lead to 1-year expected returns being lower than starting yields.

United Kingdom

Similar to our views on the US, our base case assumes that UK inflation continues downwards, but inflationary pressures persist. We expect the BoE to cut and additional two times over the course of the next year, which is currently less than market expectations

Our base case assumption is marginally more bearish than the forward curve is pricing in. Our slight shift upwards in the yield curve over the year, following the recent market rally in gilts will means our 1-year expected returns are somewhat subdued.

Recession scenario

United States

In a recessionary scenario, a slowdown in economic activity may see inflation quickly drop to the Fed’s 2.0% target. This would allow the Fed to cut interest rates to around 3.0% (currently at 5.5%).

We would envisage the two-year yield drops to around 2.5% on expectations of future rate cuts. Ten-year US treasuries would likely rally to a 3.0% yield as the market takes a risk-off tone. But the excess returns an investor obtains from committing to holding a long-term bond instead of a series of shorter-term bonds (the ‘term premium’) is back due to uncertainty around the outlook for the economy, causing an upwards sloping yield curve.

United Kingdom

In the scenario of a UK recession, inflation may likely drop to the BoE’s target 2.0% quicker than expected (currently at 2.2%). This would allow the BoE to cut interest rates more rapidly than expected to around 2.5%.

Consequently, the two-year yield should drop to around 2.25% on expectations of future rate cuts. Again, the ten-year UK Gilts would likely rally to a 2.75% yield on the back of a risk-off tone, but term premium would be added back into the equation due to economic uncertainty.

Yield curves could shift further downwards which has the potential to result in large gains when risk-assets (equities) are selling off. This is similar to what we saw during the recent market flash crash. For this reason, bonds with a longer duration have the highest one-year return expectations.

Inflationary reacceleration scenario

United States

In our inflation scenario, we would imagine the Fed will keep rates restrictive, causing a general upwards shift in the yield curve.

This may cause the two-year US treasury to sell off to around a 5.0% yield on the back of higher embedded rates. We would also expect the ten-year US treasury to sell off, but to settle at 4.5% causing the yield curve to reinvert given restrictive policy and recession fears.

United Kingdom

If inflation begins to accelerate in the UK – which we view as low-risk outcome at this time – the BoE will likely keep interest rates restrictive. The entire yield curve would likely shift upwards and invert once more, as investors expect higher base rates to remain in place for longer.

We believe the two-year sells off in Gilts would lead to a yield of 4.75% on the back of higher embedded rates and the ten-year selling off to 4.25% -lower than the policy rate sensitive two-year bond.