Executive summary
This week we look at three important issues:
- US long-term yields: Higher for longer reloaded. US 10y government bond yields have risen above 4.6% amid expectations of a slower rate-cutting cycle by the Fed, which recently admitted that inflation is taking longer to return to target. But even if the Fed implements only two rate cuts this year – down from our initial expectation of four – we would still expect long-term yields to correct downward from current levels. Market pricing for terminal rates is significantly above our estimates and therefore poised for a downward adjustment, which will drag long-term yields down as well.
- EM financial markets - fasten your seatbelts. Risks of a delay in Fed rate cuts are casting a shadow over emerging markets, which have faced heightened volatility and currency depreciations. As a result, EM central banks are caught between a rock and a hard place, unable to deliver the amount of rate cuts anticipated just a month ago. This shift pushed up sovereign bond yields, surpassing our year-end expectations, although spreads in hard currency bonds remain tight. Going forward, we expect a gradual decline in yields in line with major bond markets (which should end the year close to 6% vs. current 6.7%), but a slightly upward movement in hard currency spreads (to 225bps from 200bps in our main benchmark). While this picture may in principle present some opportunities, we remain very cautious as downside risks have also increased.
- Inflation and election results: There is no nexus. Looking at 107 elections in 63 major developed and emerging markets since 2021, we do not find that inflation has affected election outcomes. At best, there is a moderate advantage for opposition candidates or parties to win if inflation was significantly higher shortly before the election. Moreover, in the 53 elections in which the latter was the case, a significantly more populist president or government was elected in only six cases at best. However, this group includes significant economies such as Argentina, Italy and the US.