Aegon AM: Government Bonds, plenty of yield to go around

29 november 2024

Government bond forecasts are largely driven by the macroeconomic expectations described in the chapter above. The front end of the yield curve is mostly set by central bank policy rates, while the longer end of the curve is influenced by expectations of future economic growth-and inflation.

United States

Now that the Fed has started to cut interest rates, it will likely continue doing so until 2026. It is unlikely that short-term rates will be reduced below 2%. Long-term rates are likely to react to better inflation reports and any economic slowdown by continuing to ease. Eventually, we expect that the yield curve will revert to upward sloping, with long-term rates above short-term rates, but the current inversion could continue for some time to come.

The Fed will likely continue reducing the size of its Treasury securities portfolio, even after it starts cutting interest rates. Fed president Powell has emphasized that it is still the Fed’s goal to lower the overall amount of Treasuries and mortgage-backed securities it holds, to get its portfolio back to a historically more normal level. From the perspective of the commercial banking sector, this is substituting interest-paying reserves for treasuries. No additional deposits are necessarily required to fund this, unlike what is often mentioned in the financial media. However, these actions will have an impact on the duration risk, which will need to be absorbed by markets. Overall, balance sheet reduction will provide upward pressure on longer-term rates.

At the same time, the US government will also need to fund its deficits, which will likely remain high regardless of who controls the White House.

Due to the combination of more sticky inflation and a large supply of treasuries, we expect longerterm rates to trade well above the pre-pandemic levels. 

Eurozone

We expect the ECB to lower the deposit rate to around 2% in 2025. Also in Europe, the more sticky levels of inflation will likely keep central bank rates in positive territory. The risk of rates falling back towards zero is larger than in the US, as growth and inflation could disappoint if Europe’s structural issues aren’t resolved.

The European sovereign bond markets are influenced by a variety of economic, political, and fiscal factors. One key aspect to consider is the real neutral rate, which for Europe is estimated to be around 0.5%. This rate aligns with anticipated productivity growth. Assuming inflation will, in the long term, fluctuate around the ECB’s target of 2%, this would imply neutral nominal rates of around 2.5%. In reality, interest rates tend to under- and overshoot this target for prolonged periods of time. However, in our baseline forecast of steady growth and inflation, we expect longer-term rates to fluctuate near this level, as they are doing at the moment.

A unique characteristic of the eurozone is the absence of a single, supranational issuer with full sovereignty. Instead, the eurozone comprises various national issuers and several European facilities, which are backed by taxes sourced at the EU level. This structure introduces credit risk based on the fiscal and economic positions of individual countries. Unlike other regions with a single sovereign issuer, the eurozone’s diverse composition means that each country’s fiscal health can impact the overall stability of the bond market.

Germany currently acts as the sovereign benchmark within the eurozone, largely due to its perceived low credit risk. This perception is supported by Germany’s low debt-to-GDP ratio and fiscal discipline, which have resulted in relative scarcity of German bonds. Consequently, German bunds are expected to trade tighter compared to the economically sensible neutral rate. This scarcity and the high demand for German bonds underscore the country’s role as a perceived safe haven within the eurozone.

The spreads of eurozone countries over Germany are driven primarily by two factors: fiscal prospects and political changes. For instance, the French parliamentary elections this year saw gains for both the far left and far right, which is likely to lead to higher deficits and a rollback of earlier reforms. French spreads had already been increasing due to persistently high deficits and waning support for reforms, rising from around 30 basis points (bps) before the pandemic to 50 bps at the start of the year. The elections added another 20 bps to these spreads.

Italian spreads, on the other hand, are currently around 140 bps. Italy faces structural challenges, including lower growth due to demographic headwinds. From a debt sustainability perspective, these spreads are considered too high, as maintaining a primary budget balance would require structural primary budget surpluses, which are unlikely. The best way to improve debt sustainability in Italy, and other similar economies, is to increase productivity growth. Given the productivity gap with the US and Northern Europe, this should theoretically be possible. But it will require significant reforms for which support seems to be minimal.

Without growth, Southern European countries face difficult choices: targeting and maintaining budget surpluses, seeking fiscal support from Northern Europe, or considering debt writedowns. Each of these options comes with significant challenges and potential economic pain, making productivity growth a pivotal factor for the future of Europe.

In our forecast for the next four years, we expect spreads to remain rangebound as we do not anticipate a resolution to these underlying issues within this timeframe. In the event of a crisis, Europe is likely again forced to take a step towards further fiscal and economic integration.

United Kingdom

The UK gilt market is currently reflecting expectations similar to those seen in the EU and US markets. The Bank of England (BoE) is anticipated to continue its rate-cutting cycle, which aligns with broader global trends. However, the UK is expected to experience higher inflation and slightly higher long-term growth compared to the EU. Consequently, 10-year gilts are forecasted to trade around 3.5%. Although higher than German bund yields, this is much lower than what current forward curves suggest. This discrepancy makes us relatively positive on UK duration.

Overall, the outlook for the UK gilt market remains cautiously optimistic due to persistently high rates being priced in.