Navigating the volatility in global bond markets

Global Bond Volatility Drivers

• US 10-year yields rose approximately 100 basis points since September; UK yields followed a similar trajectory, while European yields increased by roughly half that amount.
• The primary catalysts are upward revisions in growth expectations, inflation forecasts, and the anticipated path of Federal Reserve monetary policy.
• US economic data, particularly in the labor market, has exceeded expectations, shifting narratives from disinflation to more inflationary dynamics.
• The December Fed meeting revision of inflation views reduced market expectations for interest rate cuts.
• Post-US election repricing strengthened across US macro assets, contributing to the broad rise in global bond yields.

Bond Risk Premia and Fiscal Factors

• Markets are demanding increased bond risk premia due to large sovereign deficits and high supply of new issuance.
• The current term premium in US 10-year Treasuries has reached its highest level since 2015, standing at approximately 60 basis points.
• Treasury issuance under the incoming administration may shift from short-duration bills to longer-duration notes, altering market supply dynamics.
• Market participants are pricing potential fiscal imbalances, trade tariffs, and labor market tightness (e.g., deportations) into worst-case scenarios.

Market Expectations and Uncertainty

• Market expectations for Fed rate cuts in 2025 shifted from pricing a single cut to including a 35% probability of rate hikes over the next 12 months.
• Uncertainty regarding the speed and scope of new administration policies (fiscal, trade, immigration, and government efficiency) has embedded higher term premiums.
• The neutral rate of interest ($r^*$), previously estimated near 3%, is now being debated as potentially closer to 4%.
• The market's sensitivity is partly attributed to the unexpected resilience of the US economy despite higher interest rates in the previous hiking cycle.

Inflation Dynamics and Tariffs

• Recent US CPI and UK inflation data showed modest downside surprises, causing yields to correct lower from recent peaks.
• Central banks remain focused on preventing "second-round effects," where initial price shocks propagate into wage demands and broader inflation expectations.
• Current indicators on wage pressures and long-term inflation expectations are deemed benign, suggesting limited spillover from temporary tariff impacts.
• Forecasters remain optimistic that underlying inflation will moderate in 2025, excluding direct tariff-affected categories.

Corporate and Investment Impacts

• Corporate debt investors are prioritizing high yields, which has kept credit spreads near multi-decade tight levels.
• Corporate earnings continue to outpace increased interest expenses, maintaining robust issuance demand despite higher borrowing costs.
• The yield curve is now positively sloped, creating an incentive for companies to issue shorter-dated debt to capitalize on lower financing costs.
• Corporates are increasingly utilizing interest rate derivatives or staggered issuance strategies to manage uncertainty rather than locking in financing all at once.

Global Divergence and Outlook

• A divergence exists between the US and the rest of the world; US yields are supported by strong growth data, whereas UK, European, and Chinese yields are rising despite anemic growth fundamentals.
• The UK's "twin deficit" economy is exhibiting high beta sensitivity to global US yield moves.
• Goldman Sachs Research forecasts US 10-year yields to fall to 4.35%, UK gilts to 4.0%, and European yields to 1.9% by the end of 2025.
• Jonny Fine, Global Head of Investment Grade, maintains a bullish bond outlook for 2025, arguing that fears regarding the neutral rate are overblown and that fiscal responsibility may materialize.
• The forward-looking view relies on continued progress in underlying inflation and the absence of significant second-round inflationary effects.