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As we start 2025, our macro indicators are hinting at a phase of nominal recovery, a scenario that traditionally bodes well for expected returns given the low defaults and earnings progression associated with such environments. However, the year has kicked off on a somewhat less optimistic note amid rising government bond yields, with long-dated rates increasing faster than short-dated ones, a move that is known as bearish steepening. Such shifts are not typically friendly to equity markets, meaning it is crucial to assess how this new rate environment might impact growth, fiscal scenarios and earnings outlooks, given long-term rates are a critical macroeconomic variable. Welcome to another year of Simply put where, this week, we analyse the new rate environment.
Read also: How could the end of free trade impact markets?
The consequences of higher long-term yields
The current situation across financial markets is quite surprising. Central banks’ dovish pivot took place between the end of 2023 and 2024, which led market participants to anticipate further interest rate cuts. Indeed, rate cuts are still being discussed across the G10 nations, with the notable exception of Japan. Typically, such rate cuts tend to fuel declines in long bond yields; however, the opposite is occurring right now. US 10-year yields have risen, firming the yields of other G10 countries with them. Since 16 September, and following the final pricing of the ‘Bessent premium1,’ US 10-year yields have increased by about 120 basis points. Consequently, most 10-year yields have regained much of their decline from the first half of 2024, resulting in significant costs for portfolios exposed to duration: a global treasury index returned -1.7% in dollar terms during this period.
Why is this important? There appear to be two main drivers behind this unexpected rise in yields. Firstly, fiscal policy is perceived to require tightening, while the future path of monetary policy is being questioned due to the persistent stickiness of inflation. These factors are significantly influencing market dynamics:
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First, when nominal yields increase more than nominal growth, it mechanically raises the future level of the domestic debt-to-GDP ratio. For instance, current data shows that Italy, the US, and the UK are facing rates that are too high for their debt trajectories to trend downwards, signalling a market call for fiscal consolidation (see the left-hand chart of figure 1)
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Secondly, when real yields (nominal yields minus inflation compensation) exceed real growth, it tends to slow down economic activity, producing a disinflationary trend. The right-hand chart of figure 1 shows that this is apparent in countries such as the US, the UK and Italy, where real yields are currently higher than real growth |
In essence, long yields are performing a regulatory function that both governments and central banks are hesitant to undertake – governments due to electoral reasons (fiscal consolidation) and central banks because of their desire to achieve a soft landing. Bonds vigilantes are back, but their power goes beyond merely pushing rates higher.
FIG 1. Comparison between nominal yields and structural nominal growth (left, debt reversibility) and between real yields and potential real growth (right, growth impact)2
Keep an eye on the US dollar
In recent times, we've observed US bond yields rising more than the rest of the G10 nations. This trend has been particularly stark at the shorter end of the curve, leading to a rapid appreciation of the dollar. Over the past six months, the dollar has gained about 6% on a trade-weighted basis. This significant uptrend could have far-reaching macroeconomic consequences.
A rising dollar typically casts a shadow over various markets, starting with a potential dampening of earnings prospects for both US and global equities. Furthermore, the increased cost of accessing the dollar could pose challenges to the earnings trajectory of EM equities. Figure 2 provides estimates of how dollar movements over a 6-month period might affect DM and EM earnings. The data suggests that the impact is generally minimal until the dollar appreciates by more than 5% for EM equities and 8% for DM equities.
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Preference Centre
Currently, it appears that we have already reached the pain threshold for EM assets. Any further dollar strengthening could begin to impact the most affluent segment of the equity markets: US stocks, which are now extremely sensitive to their earnings projections. As we approach the earnings season, there are ample reasons to remain cautious. Investors and market analysts should pay close attention to these dynamics, as the interplay between the rising dollar and global equity earnings could dictate market trends and investment strategies in the upcoming months.
FIG 2. Estimated impact on earnings growth of a 6-month rise in the US dollar3
What this means for All Roads
In light of the macro risks associated with current higher yields, our investment dashboard has prompted a reallocation of our investments. We are subtly shifting away from DM and EM equities in favour of inflation swaps and credit spreads. Additionally, we have taken a prudent step in revising our total market exposure downward. Currently, it stands at 110%. This adjustment reflects a strategic move towards greater caution in response to the higher yield environment, ensuring that our portfolios are better aligned with the evolving economic landscape and market conditions.
Simply put, higher yields are temporarily weighing on economic and market perspectives.
To learn more about our All Roads multi-asset strategy, click here.
Macro/nowcasting corner
The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.
Our nowcasting indicators currently show:
- Our growth signal continues to show a global growth improvement from lower levels
- Our inflation nowcaster is on an upward trend, but only a minority of the data has risen on a 1-month change basis. In the US, 36% of inflation-related data has risen recently
- Signals from our monetary policy nowcaster have weakened in the eurozone and China, and remain stable in the US. Neutral to dovish monetary policy seems to be in order
World growth nowcaster: long-term (left) and recent evolution (right)
World inflation nowcaster: long-term (left) and recent evolution (right)
World monetary policy nowcaster: long-term (left) and recent evolution (right)
Reading note: LOIM’s nowcasting indicator gathers economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).