Update Bonds: Outlook for yields increasingly complex
Bond markets were stirred up this week by disorderly increases in Japanese government bond (JGB) yields and an escalating conflict over Greenland between the US and Europe.
JGB yields surged as Prime Minister Sanae Takaichi came with an election pitch including unfunded tax cuts. When yields rise in a disorderly manner, there is a risk that they will do so until something breaks. Japan’s Minister of Finance’s call for calm helped to stabilize markets for now, but it is a reminder that investors remain focused on debt sustainability.
The Europe/US conflict over Greenland escalated early in the week, but fears for a trade war (or worse) now look resolved following Trump’s visit to the World Economic Forum where he abandoned his tariff plans, and as the US and NATO agreed on a framework for a future deal. We have to wait to see how this progresses, but even if this conflict is resolved, geopolitical risk remains high. Heightened conflict risk tends to support core yields via safe‑haven flows. However, there is a risk that foreign investors will diversify away from the US dollar and US assets, if they believe that the US can no longer be trusted. US debt sustainability could then quickly return as a dominant theme.
US economic growth continues to power along, but Trump needs to deal with an affordability crisis. His ideas on resolving this crisis share the common theme of using fiscal stimulus. This will most likely make things worse in the long term. Nonetheless, the Trump administration may pursue it anyway, as the November midterm elections loom. Adding even more stimulus to a strong economy where inflation remains high does not bode well for US Treasury yields.
In the shorter term, yields may also come under pressure from the Supreme Court’s ruling on the legality of Trump’s tariffs. It is expected any day now and would especially impact yields if the Supreme Court rules that collected tariffs need to be paid back. This is, however, not our main expectation. Furthermore, Trump is to announce his new Fed Chair potentially as soon as next week, and markets will interpret what the nominee may mean for the independence of the Federal Reserve.
Uncertainty remains high, but has become skewed toward higher yields, inflation and debt sustainability concerns rather than recession risk. Against this backdrop, we expect the US Treasury yield curve to steepen further. In euro-denominated investment-grade bonds, higher spreads on corporates than on sovereign bonds (including peripheral sovereigns) look attractive when risks are skewed toward higher yields and debt sustainability rather than recession.