Decoding the bond sell-off

0:01Patrick Coffey:Welcome back to the Barclays Brief podcast. It's Patrick here. Last week, something important happened in bond markets. Long-term yields didn't just move higher in one country. They broke everywhere. The UK, the US, Japan, France, all seeing decades-long highs at the same time. And when that happens, it's no longer a local story. It's something more structural. So what's really driving this move? Is it inflation, fiscal policy, or something deeper about how markets are pricing risk today? To unpack it all, I'm delighted to be joined by Lucille Flight, MD from our rates trading desk here in London.

0:39Patrick Coffey:Lucille, thanks for finding time on a busy day in markets to join me in the studio. Thanks for having me. I'm really excited to be here. There's a lot to talk about, but this is my first podcast, so go easy on me. Well, let's start with a question that everyone's asking right now, which is what's going on with global bond yields? What's driving the move? What's changed? And what's changed particularly in the last couple of weeks? Sure. So the sell-off initially started alongside the war in Iran, and that's essentially a function of inflation expectations from higher energy prices. and also what any secondary effects would be from those higher energy prices and higher kind of headline inflation.

1:25More recently, the long end has participated slightly more in the sell-off, particularly in the US and in the UK. And there have been some interesting themes emerging in those markets specifically that are running alongside the geopolitical tensions in the Middle East. And those are essentially political in nature in the UK. and I'd say a shift in longer term neutral rates in the US.

1:51Patrick Coffey:So let's just start in Europe. The ECB's tone seems to have shifted quite a lot over the last couple of months. For our listeners, can you just explain what's happened since the start of the war in Iran and where is the ECB now? Sure. So the ECB is probably the simplest market to talk about because there are fewer themes at play here. Essentially, we had a sharp bear flattening in the euro rates market from the get-go when the war in Iran started. And the ECB really corroborated that market view because they came out essentially focused entirely on the inflationary impact of the war in Iran. And that's when markets started pricing in quite aggressive hiking.

2:34Yeah. In fact, we even broke through 25 basis point increments in the very front end of the euro rates market. Now, since then, that's mellowed down. The ECB sounded slightly less hawkish than they did at the start of the war. Lagarde, you know, really highlighted how much financial conditions have tightened already. And I think that poured cold water on this view that the ECB was going to hike aggressively and, you know, in 50 basis point increments from the get go. So with that, you know, we've priced a little bit less in the very short end of the curve, but we've priced out some of the inversion in the 2027 forward.

3:10So you're pricing less of an extreme scenario that the ECB would then need to reverse quite drastically a year later.

3:18Patrick Coffey:Yeah. So a lot's happened in a couple of months there. A lot has happened in a couple of weeks in the UK. We're talking about extreme scenarios there. There's this shock of inflation and there's also political instability in the UK. The question I have for you is, we're seeing such volatility in the GILTS market in the UK. how much of that is about the economic outlook and how much is actually about fiscal credibility and political uncertainty? Yeah, so I'd say the UK market started much like Europe with this kind of sharp bear flattening and it was really a function of the war in Iran predominantly.

3:57More recently, like you pointed out, there's another dominant theme in the UK which is political uncertainty, particularly, you know, the future of the Labour Party and who will lead that party in the long run. And what that really means for markets is how much spending will increase and subsequently how much debt issuance there will be. That's really the market focus for the long end of the guild market. And for that reason, although, you know, you've had the front end reprice cheaper in sympathy with kind of re-escalation risk in the Middle East, the flattening has been somewhat mitigated by this increased risk premium that the guilt market needs to price in the long end as a result of the political uncertainty yeah so your clients and

4:43Patrick Coffey:your colleagues presumably are looking for any little hints any tidbits from potential candidates for that labor leadership and think about what that would mean in terms of the fiscal outlook for the uk that's exactly right that's particularly relevant for the long end of the curve what about so there's a I don't know if irony is the right word but when the MPC next meet is the same day as the by-election results in Makerfield where Andy Burnham's standing what's the expectation around what might happen in that June meeting? Yeah so it's a really interesting question and it's actually a point that Jack Meaning so our chief UK economist here at Barclays pointed out the Bank of England is not going to want to make a meaningful monetary policy decision on a meaningful political event as well.

5:34Patrick Coffey:Yeah. So lots to watch there in the UK. And I suspect we'll see, you know, lots of headlines coming up on a kind of hourly basis, certainly daily basis. Let's move to the US, which has been a very resilient economy. But the 30-year yields there has gone through 5%, as I referenced earlier. So there were some concerns around the fiscal outlook there. What's going on in the US when you look at it from a rates perspective? Yeah, the US has been really interesting. Before the war broke out, the focus was really on AI and what that meant for the labor market and inflation short-term and long-term. And I think John Hill mentioned this in your podcast last week, which is definitely worth a listen.

6:16But on the labor side and labor impact of AI, the consensus view was essentially that it was a replacement for labor. And so the market was looking out for, you know, the labor market falling out of bed, unemployment increasing, and essentially the Fed needing to respond with lower rates in the short term. Now, we haven't seen that play out. The labor market has been stuck in this low hire, low fire environment. And there is an argument that, you know, the break even job growth rate is lower just because there's, you know, no immigration at this point in time. And so the market focus has shifted from, you know, concerns around the labor market as a result of AI to whether actually we're in this environment where the breakeven rate is lower and therefore potentially a terminal, you know, neutral rate is higher.

7:09So potentially we're not at restrictive levels here and now. And so, you know, that coincided with re-escalation in the Middle East and that allowed for the U.S. market to participate in the global sell-off much more this time around in the last few weeks, essentially. There's been a lot of focus on 30-year yields. What I would point out is actually the curve's flattened in the last couple of weeks. So it really has been the front end that's leading this move. And we are having a bear flattening move. You know, I would urge our listeners to read Anshul Pradhan's last piece, which is super interesting.

7:43It talks about U.S. yields in the long end, particularly 30-year yields and the spread to Fed funds over the last 40 years. Long story short, he shows that 30-year yields are right at the average spread over Fed funds, adjusting for very low or very high policy rate environments. And his conclusion is that 30-year yields are not cheap versus the rest of the curve. And it's also something that our clients are talking about a lot right now as well.

8:09Patrick Coffey:Yeah, I'm sure. I bet your clients are also talking about this, which is what would stop this sell-off in the global bond yields? What's the catalyst that's going to bring yields meaningfully lower again? I'm sure you're about to say the Strait of Hormuz, but is there anything else that could change things? The most obvious answer is an immediate reopening of the Strait of Hormuz and, you know, a credible agreement and resolution in the Middle East. Beyond that, I think, you know, if things don't normalize in the Middle East, we need to have it. It needs to come from growth expectations. And what that would require is a strong response from central banks such that monetary policy is tightened to the extent that it tightens financial conditions enough that it dampens long end growth expectations.

8:57I think that would then help contain long end yields. Okay.

9:04Patrick Coffey:And when you put it all together, and I know you look globally at all of these, we haven't even talked about Japan today. I know, there's no time. No time, but we've had huge moves in the 30-year yield as well, year to date. But put it all together, where are you seeing the most interesting kind of trading opportunities right now? Where's the risk reward look most compelling for you? Yeah. So investors are really interested in the belly of the euro curve and specifically the two year, two year point, which is reaching 3%. And when you when you zoom out to even 2022, 2023, there is a pretty strong resistance around that 3 % level.

9:42And essentially, that's because two-year, two-year, you're looking past short-term monetary policy responses to energy price shocks. You're looking past the immediate growth impact that those monetary policy moves might imply. You're looking at terminal rates. And 3 % seems quite toppy in Europe long-term. Another angle that I think clients are interested in is in the front end of the UK market, which we've talked about at length, specifically in the next June MPC meeting. There's still eight basis points priced and we talked about why we think it's unlikely that we get a rate move at that point in time.

10:19Patrick Coffey:That is going to be a very interesting day in June. Looking forward to seeing what happens there. And Lucille, thanks a lot for joining. It's been great to have you on a busy day in markets. Thanks for having me. So the takeaway is clear. This isn't just a series of local bond market stories. Major bond markets are facing a similar set of challenges. We're seeing a broader repricing of duration, driven by fiscal realities, persistent inflation risks, and some political uncertainty, as well as a more demanding investor base. And it's hard to point to a near-term catalyst outside of the reopening of the Strait of Hormuz that could fully reverse the current sell-off.

10:59Patrick Coffey:Now that doesn't mean it's a crisis, but it does suggest higher yields and more volatility may be here for longer. Thanks for listening to the Barclays Brief Podcast. Do hit subscribe and we'll be back again next week at the same time.