As global interest rates diverge: keep it short and stay active

After keeping markets in suspense for most of the summer, the US Federal Reserve finally leapt into action in September, making a bold, 50-basis-point rate cut.¹ This was an important statement; rates are coming down and bond yields should follow.

The Fed, however, has not been the only central bank to have made big moves in recent weeks. We’ve also had a 50-basis-point cut from the Reserve Bank of New Zealand and there’s good reason to believe (based on its statements) that another 50-basis-point cut will follow in November.² In contrast, central banks in Norway and Australia have retained a hawkish bias, while the Bank of England seems to be cautiously following the gradual easing bias of the European Central Bank.

The differing messages coming from the world’s major central banks – and their ongoing policy divergences – are summarised below. The overall picture is that… there is no overall picture. For rates specialists like me, that means things are starting to get interesting.

Central bank policy decisions: a summary

A fascinating setup for bond markets

The overall trend is towards lower rates, making this is a good time to own bonds. The post-pandemic experiences of the world’s major economies have, however, been quite different. The result is that monetary policy across the world’s currency blocs is increasingly falling out of step.

• The Bank of Japan is still discussing whether it may need to push rates higher.
• The Bank of England and the European Central Bank are suggesting their policy will be one of gradualism.
• The Reserve Bank of New Zealand and the Bank of Canada are discussing the possibility of cutting rates more aggressively.

Despite these clear divergences, investors currently seem to be pricing in relatively uniform rate-cutting cycles. This lack of discrimination creates opportunities for active bond investors with the tools and expertise to be active in the global rates market: we can exploit pockets of relative value that are being created by a desynchronised global rate-cutting cycle using cross-market trades.

The prospect of a steeper yield curve underlines the attractions of short-dated bonds

Clearly, in addition to deciding where to invest your capital you need to decide how much interest-rate risk to take. Making the right call on duration is important. And I would argue this might not be the time to uncritically add as much interest-rate risk to your bond portfolio as you can. How much confidence can you have in your interest-rate forecasts?

There’s simply no need to make your portfolio a one-trick pony when real yields towards the short end of the curve are as attractive as they are today. You’re getting a similar yield to the yield on longer-dated bonds – but with almost none of the interest-rate risk and lower volatility.

There’s simply no need to make your portfolio a one-trick pony when real yields towards the short end of the curve are as attractive as they are today.

My central expectation is that the Fed will cut rates by another 50 basis points if the jobs market doesn’t show signs of recovery. That leads me to believe anything in the US yielding more than 3% with up to five years to maturity is currently a ‘buy’. And, while I do think there are risks to the upside for yields in the US, I see these risks as being concentrated towards the longer end of the yield curve.

And, while I do think there are risks to the upside for yields in the US, I see these risks as being concentrated towards the longer end of the yield curve.

In the US, the 2-Year/10-Year curve is still unusually flat when looked at from a historic perspective.³ This is despite the fact that we would expect to see that curve steepening in a rate-cutting cycle. To me, this underscores the unique attractions of short-dated bonds at this point in time.

Where active bond investors can find the sweet spot between risk and reward

So, while these are supportive conditions for active bond investors, these are also uncertain times. These are perhaps not the conditions in which to blindly take on interest-rate risk. Instead, it may be good time to look at the short end of the curve to find the sweet spot between risk and reward.