Global growth has roared back the last few months, while inflation rates have popped a lot higher, which is in line with what we (and many others) have been expecting for a long while.

Interestingly, however, longer-dated sovereign bond yields are largely unchanged versus where they were in mid-March, which has left some investors scratching their heads.

We think that the reason is very simple – following the bond selloff of the past half year, and particularly after the move in February this year, valuations on longer-term bonds are not expensive. We touched on this in our blog from March, when we asked whether the bond market selloff meant that government bonds were becoming attractive (see Make no mistake, this is a full blown tantrum - Bond Issues). We concluded that while we didn’t want to be outright bullish of core rate duration yet, it no longer made much sense to be outright bearish either given the improved valuations. We thought bond yields were mostly likely to move sideways, and that’s what has essentially happened.

The first chart below is an update from the blog comment linked above. Looking at the US, longer-term market-implied interest rates are back to the average of the last half decade, and in fact similar to average market expectations of the last decade.

5y5 Forward US Treasury Rate & 5y Moving Average

Source: Bloomberg as at 19.05.2021. Past performance is not indicative of future performance.

If investors believe that long-term bond yields will continue to soar, they need to believe that we are about to enter a new paradigm of higher inflation and/or growth. But as discussed in March, we view the surge in growth and inflation as temporary – the fiscal stimulus will reverse, monetary stimulus will slowly reverse, supply bottlenecks will be overcome, and commodity prices will not treble every 12 months.

Meanwhile, we are increasingly confident that some of the huge recent cyclical tailwinds, such as the fourth great credit bubble that China engineered in 2020, will become headwinds over the second half of this year. Indeed, the commodity price surge itself should put a break on growth later this year too, even more so than when Jack Norris wrote about this in March. The long-term drivers of global growth, and indeed of global sovereign bond yields – namely steadily deteriorating demographics and sharply higher debt levels – will kick in again from next year.

The charts below provide a bit more colour on what long-term interest rates markets are now pricing in, taking the 5 year 5 year forward rate on a range of different sovereign bond markets. While market-implied long term interest rate expectations (i.e. longer term yields) are back to the average of the past 5-10 years, yields in many emerging market (EM) countries appear outright cheap on an historical basis.

Lower Yielding Developed Markets

Source: Bloomberg as at 19.05.2021. Past performance is not indicative of future performance.

Fund implications

Although the renewed surge in commodity prices in the past couple of months means inflation will be a little higher over the second half of this year than we previously expected, we still maintain that most sovereign bond yields are around fair value. We moved marginally shorter duration as yields edged lower in early May, but the upwards pressure on yields since then have made valuations once again more supportive. Our key convictions in rates markets – that valuations in most developed markets are OK, and valuations in most EM local rates markets outright cheap – are still reflected in the portfolios, depending upon the different mandates. Fund durations are currently close to neutral, with the exception of the Allianz Index-Linked Gilt Fund, where we believe UK real yields are more likely to rise and are therefore positioned short duration.

The area of global fixed income markets that we are worried about now is not rates markets, but credit. This is the exact opposite of the views we had in Q2-Q4 2020, when rates markets looked very expensive and credit markets relatively cheap. For more information on why we have such high conviction to be underweight of credit risk, then please see the recent comment from Jack here.

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