Over the past few months bond yields have drifted higher again, with US Treasuries leading the way. Optimism around the US economy have markets further embracing a so-called ‘soft landing’ scenario instead of the ‘hard landing’ recession variant. In this economic environment, central banks continue to be determined to curb inflation by tightening monetary conditions within the context of a risk-management approach, as we outlined in our previous outlook ‘Tie Break’.

Central banks aim to err on the side of caution, thereby accepting the risk of tightening too much to bring inflation back under control. With inflation receding already, real rates are set to rise regardless of any further hikes in official rates. The combination of elevated real rates, tighter lending conditions and less fiscal support should weigh on growth. In particular, the Eurozone seems to be at risk of a more pronounced slowdown, and it seems unlikely that the US will fully escape the global slowdown.

We believe that policy rate peaks are close or have arrived and that in both a ‘hard’ or ‘soft’ landing scenario bonds can rally from current levels. Even as curves have retraced somewhat from the profoundly inverted levels seen at the end of Q2, they remain in deeply inverted territory. Inverted curves tend to normalize overtime, as the impact of tighter monetary policy hits the economy.

Credit markets have continued to do well in the past few months, as spreads benefitted from the soft-landing narrative. Nonetheless, we expect the impact of policy tightening to start manifesting in the broader economy amid decelerating growth and tougher lending environments. Hence some caution is warranted.