Bond markets fret over rising budget deficits

An uncertain economic backdrop has pushed up long-term government bond yields in comparison to those on the short end, which are typically more linked to central bank policy rates. As a result, many countries face the mounting cost of servicing debt interest payments which, in turn, threatens to squeeze government spending. At the same time, investor demand for long-dated sovereign debt appears to have softened.

“To navigate the current global bond market sell-off, it’s important to understand the key drivers at play – and they are multiple: political uncertainty, particularly in Europe, and persistent budget deficits across major economies,” says Mitch Reznick, Group Head of Fixed Income – London, Federated Hermes Limited. “We’re not seeing strong momentum toward shrinking budget deficits and, with summer over, the increase in supply and lack of appetite from both the US and Europe is impacting yields at the long end of rates curves.”

Compounding the situation, inflation numbers remain stubbornly above central bank targets and appear to be creeping upwards in a number of countries.

Fed easing looms

In the US, weak jobs data released this week added to expectations that the Federal Reserve will cut interest rates at its Jackson Hole meeting later this month and could move more aggressively on policy easing. “Some of these effects are temporary, while others reflect deeper, longer-term shifts,” says Reznick. “In the near term, long-end funding costs for corporates will be higher. We’ve had rate steepeners in place for a while, and now we’re evaluating whether it’s time to unwind those positions or even reverse them. Certainly, the front end — from the belly to the front, across credit and fixed income — remains a relatively stable place, albeit somewhat crowded.”

Mo Elmi, Senior Portfolio Manager for Emerging Market Debt at Federated Hermes, says that, despite emerging market (EM) sovereign debt and corporate credit offering a higher spread cushion compared to other fixed income asset classes, EM credit has not been immune to the global bond market sell-off. “The impact has not been uniform across EM debt. Bonds issued by tight-spread investment-grade issuers, which have leveraged their strong credit profiles to issue long-dated securities, are more vulnerable to the sell-off at the long end of the curve. In contrast, bonds from high-yield frontier issuers, which tend to issue in the short-to-intermediate part of the curve, will be less exposed to this dynamic.”