| • Selective opportunities emerging in gilts as growth risks are underestimated. • Central banks’ messaging has diverged sharply, prompting rapid repricing from rate cuts to multiple hikes. • Volatility is expected to persist, keeping gilt valuations and growth risks in sharp focus. |
Fears of a spike in inflation and an increasingly hawkish tone from central banks have driven exceptional volatility in government bond markets but investors may have overreacted.
Stuart Chilvers, fund manager of the Rathbone Ethical Bond Fund and Rathbone Strategic Bond Fund: “While uncertainty remains high, some of the repricing looks excessive. On balance, we think markets have moved too aggressively in terms of interest rate pricing.”
Financial markets have been hit by events in Iran and across the region. Initial optimism quickly gave way to sharp selloffs and rebounds, with government bonds, which are sometimes seen as risk-free, caught in the eye of the storm.
The reaction has been amplified by a sharp divergence in central bank messaging. While the US Federal Reserve has adopted a more balanced, ‘wait-and-see’ approach, both the Bank of England and the European Central Bank have struck a notably more hawkish tone.
Markets have responded forcefully. Expectations have swung from anticipating rate cuts to multiple hikes within weeks, a shift which may underestimate the risks to growth.
Chilvers continues: “We’ve been somewhat surprised that both central banks and markets have seemed to take a sanguine view of the potential hit to growth,” he says. “Risks of a slowdown look particularly acute in the UK, where growth was already anaemic and unemployment has been trending higher.”
Comparisons with the inflation surge of 2022 may be misplaced: key differences including higher starting interest rates, a softer labour market and less supportive fiscal policy. Chilvers adds: “Against this backdrop, government bond markets have experienced a pronounced sell-off, particularly at the short end, as investors rapidly reprice rate expectations. However, this volatility is now creating opportunities.
“We think this volatility has opened up attractive opportunities to increase our exposure to gilts. Even if the currently priced-in rate hikes materialise, we expect central banks may ultimately be forced to cut rates further than anticipated as growth and employment come under pressure.
“Looking ahead, volatility is likely to persist, with fiscal concerns, including potential government support for energy costs and increased defence spending, set to come back into focus.
“Given the speed and scale of recent moves, we expect to take advantage of our flexibility and remain very active,” Chilvers says. “Markets may have moved too far, too fast and that’s where selective opportunities are beginning to emerge, which active bond managers should be uniquely placed to take advantage of.”
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