Four reasons why the bond market rout may be over

Rolled euro banknotes are placed on top of US dollar banknotes in this illustration taken May 26, 2020. REUTERS/Dado Ruvic/Illustration/

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May 13 (Reuters) – The battered U.S. and German bond markets just posted their best weekly performance since early March, suggesting that a painful spike in yields driven by high inflation may finally ease as the attention turns to growing fears.

Gilts in Britain, where the Bank of England has warned of a potential recession, posted their best performance since 2011.

Central banks have only just begun to tighten policy and inflation remains high, so caution is warranted.

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But here are four key shifts that suggest a turning point for the world’s biggest debt markets.

1/ NO CONVICTION

The main benchmark 10-year bond yields failed to hold above critical levels: 3% on US Treasuries, 2% on UK gilts and 1% on German Bunds. , ,

“The fact that we didn’t hold that was taken as a signal that there wasn’t so much conviction behind the high yields,” said Antoine Bouvet, senior rates strategist at ING.

Investors are hedging underweight positions in rate-sensitive U.S. bonds, typically older ones, to levels last seen in early 2021, BofA said in an investor survey Friday. Respondents viewed short rate positioning – bets that yields will rise further – as the most crowded trade.

2/ PEAK INFLATION?

Market inflation expectations have fallen particularly since the US Federal Reserve raised rates on May 4.

Inflation breakevens, which measure the difference between nominal and inflation-adjusted returns, fell further after US data this week suggested inflation could be peaking. Read more

The US 10-year equilibrium rate is 2.7%, compared to more than 3% in April. It fell 20 basis points this week alone, the biggest weekly drop since April 2020.

The eurozone five-year and five-year forward inflation swap, tracked by the European Central Bank, fell to a low of around two months at around 2.16%.

These falls were driven by soaring “real” inflation-adjusted yields. Real US 10-year yields jumped 25 basis points over the past two weeks, German equivalents rose 43 basis points.

US inflation-linked bonds (TIPS), a key hedge against future inflation, have seen outflows over the past three weeks, according to BofA citing data from EPFR.

If the markets are right, “central bank inflation problems are less severe than what the market viewed as weeks or months ago,” said Arne Petimezas, principal analyst at AFS Group.

Inflation breakeven points in the United States and in the euro fall

3/ LOWER TERMINAL RATE

With inflation expectations falling, markets have reduced bets on the “terminal rate” – where this bullish cycle ends. This is a sign that investors believe fewer hikes may be needed to contain inflation.

In the United States, money markets imply that rates will rise to around 3% in mid-2023, from around 3.5% in early May. In the euro zone, where economists have warned that the prices of the rate hike are excessive, the key ECB rate is estimated at around 1.2% in 2024, down from around 1.5% last Friday.

“The big move in bonds has been accompanied by a reassessment of the rate outlook for the Fed, (the Bank of England) and the ECB,” said Divyang Shah, strategist at Refinitiv’s IFR Markets.

This is “very different from previous corrections for bonds which did not last as expectations continued to rise.”

ECB rate hike bets

4/ HAVEN OF SAFETY

Finally, this week’s outstanding bond performance was accompanied by a 4% decline in global equities, returning top-rated government bonds to safe haven status.

This inverse correlation had recently broken down as stock and bond prices fell together in the face of soaring inflation.

In the US, this is the first week since late March that 10-year bonds and the S&P 500 are expected to end in opposite directions.

“What’s missing is that risk aversion means a rally in bonds,” said Nick Hays, head of sterling rates and credit at AXA Investment Managers. “It doesn’t always work, but we can’t go on too long where bonds don’t behave like a safe haven.”

Yoruk Bahceli

(This story corrects paragraph 27 to say “late” not “early” March.)

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Reporting by Yoruk Bahceli; additional reporting and editing by Dhara Ranasinghe and David Evans

Our standards: The Thomson Reuters Trust Principles.

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