Fund managers have been snapping up government bonds after a brutal sell-off triggered by the Iran war, as they bet that the market’s focus will shift from inflation fears to the likely hit to economic growth from the conflict.
Big investment firms including Schroders, M&G Investments and JPMorgan Asset Management have added to their holdings of debt as yields hit multiyear highs, in the belief the returns now on offer do not account for a probable weakening of growth that could require future interest rate cuts and trigger a bond rally.
“We think the market is underpricing the probability that central banks will have to cut interest rates further out, in order to offset the growth shock,” said Ben Nicholl, a senior fund manager at Royal London Asset Management, which has been buying three-to-seven-year gilts in recent days.
A surge in the price of Brent crude from just over $72 a barrel to almost $120 sparked a rout in government bonds in the early weeks of the Iran conflict, as traders bet a sharp pick-up in inflation would prevent central bankers from cutting interest rates and could force some to raise them.
That pushed yields on 10-year Treasuries up more than 0.5 percentage points to a high of nearly 4.5 per cent, while the equivalent yields on gilts jumped nearly 0.9 percentage points to more than 5.1 per cent.
However, yields have since come off their conflict highs — despite another burst of volatility on Thursday following US President Donald Trump’s threats to escalate attacks on Iran — as some managers point to the start of a shift in investors’ focus towards growth concerns.
“The growth risks are real,” said Andrew Sheets, global head of fixed income research at Morgan Stanley, which moved to a bullish recommendation on US Treasuries at the end of last week “on the belief that the market previously had been overly focused on inflation risks” and was not reflecting the hit to demand.
Iain Stealey, international chief investment officer for global fixed income at JPMorgan Asset Management, said he had been buying long-term debt in Europe, Asia and North America.
The “knee-jerk reaction” to focus on inflation was “probably overdone”, he said. “If you are a central banker today, the most obvious thing you would do is wait and see.”
Schroders had bought Canadian government bonds in recent weeks, in a bet that interest rate rises priced in by the market were “inconsistent with the economic fundamentals”, according to strategist James Bilson, who pointed to a soft labour market and a cooling economy.
Some managers argue that bonds will perform well, whether or not the war ends quickly.
Bonds present value whether there was “de-escalation from here or, on the other hand, a significant escalation or policy error-induced growth scare”, said Arun Sai, senior multi-asset strategist at Pictet Asset Management.
Jamie Searle, European rates strategist at Citi, said that even if there was a quick de-escalation of the conflict, “there would still be significant uncertainty over long-term disruption to energy supply [and] the market should pivot more to pricing the medium-term growth consequences”.
Surging oil and gas prices have driven up short-term inflation expectations across the globe, with one-year US inflation swaps going from about 2.5 per cent at the outbreak of the conflict to just above 3.1 per cent.
But longer-term market expectations for US inflation have not kept up. The so-called five-year, five-year — which shows expectations for inflation over a five-year period starting in half a decade’s time — is little changed at about 2.4 per cent.
Some bond investors are now focusing their attention on economies where weak growth was already a concern prior to the conflict, meaning that rate cuts could be on the cards again soon.
“Even if [the Bank of England] does need to hike [rates], we think those hikes would be reversed in the following years,” said Steve Ryder, a portfolio manager at Aviva Investors, pointing to the UK’s slow growth going into the crisis. He has been adding to his exposure to short-dated gilts.
M&G also added to its gilts positions last week when the market was pricing more than two rate rises by the BoE, said Andrew Chorlton, fixed income chief investment officer at M&G. “Given the underlying [economic] weakness, we felt that was too much.”
But, with government bond volatility high and the Trump administration’s next policy steps seen as hard to predict, many managers are reluctant to go all-in on bets on a bond market rally yet.
“We’re watchful, but not yet ready to say this is a great opportunity to buy,” said Citi’s Searle. “The risk is that we get a headline that prompts oil prices to jump sharply higher, and yields follow.”
Additional reporting by Rachel Rees in London
