[Edmund Shing]: Hello and welcome to a new podcast from BNP Paribas Wealth Management. I'm Edmund Shing, Global Chief Investment Officer based in Paris. Today we're going to look at the recent sharp rise in central bank rate expectations and also in long-term bond yields. To do this, I'm joined by my good colleague, Deputy Chief Investment Officer, Guy Ertz, from Luxembourg. Hello there, Guy.
[Guy Ertz]: Hello, hi.
[Edmund Shing]: So, Guy, I mean, let's just kick off. Central banks have started to raise rates again: U.S., Europe, Japan after the beginning of the Iran conflict, and of course, the subsequent energy prices. At the moment, if you look at market prices today, they are expecting three to four additional rate hikes, both from the Fed and from the ECB. Seems a bit high to me. But do you agree with this expectation, Guy?
[Guy Ertz]: Well, to put it simply, no, we don't. But we do agree that in the past few weeks, few months, as the conflict has lengthened and as there is sustained pressure on oil prices with oil prices above hundred, there is of course here the challenge for central banks to reevaluate the situation when it comes to the dilemma between maximizing employment but keeping inflation close to target, and the target being two percent.
So the central banks are still under pressure in the current environment, and we have now decided to increase the rate, the forecast, for the coming twelve months. We do now include one more rate hike of twenty-five basis points for the Fed and one more for the ECB. So that means really in practice that for the Fed we're looking for one more rate hike in December, another in January. Then we have the ECB with a rate hike in December, one hike, then only. We have the Bank of England with one more rate hike in November. That an unchanged scenario. And also unchanged is the scenario for the Bank of England, sorry, for the Bank of Japan. Here we look for a sequence of rate hikes, and we're actually looking all the way into next year, and even in 2028 with a terminal rate of two point five. That's the context, really, for central banks. So more to come, and a slight revision in our scenario.
[Edmund Shing]: Okay, so the slight revision leading us to expect benchmark interest rates for the ECB to rise from the current two point five percent to two point seven five. And the Fed should end up in January after the two rate hikes you mentioned at the range of 4.25 to 4.50 if I'm correct.
[Guy Ertz]: Yes, absolutely.
[Edmund Shing]: Right. Okay. So yeah, let's so basically rate hikes, but nothing too aggressive. And I think this is important to note because clearly, when I think about asset classes and I think what is the impact of these central bank expectations, what we always worry about is a rapid and prolonged series of rate hikes, particularly from the Fed, because typically that is signal the end of a bull market for stocks and the beginning of a bear market, and also raises the risk of recession quite dramatically. But you're not looking for that type of scenario. You're looking for a more gentle, shorter rate hiking cycle, right?
[Guy Ertz]: That's correct. I mean, we also need to know that we have an assumption here that the oil flows in the region around the Strait of Hormuz are starting to normalise, despite the fact that we don't have an end to the conflict. So, we're looking gradually for lower oil prices. So, from that side, that should limit the pressure on the central banks. And also for markets what's interesting is that rates will be rising for a good reason, which is the fact that we are expecting, and the market is expecting, more growth and more growth also via more demand for capital for business investment.
[Edmund Shing]: Yes. So exactly. So we have an economic scenario where we have pretty robust growth globally, but accompanied by inflation that is remaining stubbornly above target to some degree because of the energy price surge that we have had since March. Right? That's pretty much where we are right now.
[Guy Ertz]: Correct. Yes.
[Edmund Shing]: So again, funnily enough, the equity market has been okay with that more or less. There's been a tiny sell-off in September, but nothing major. Actually, the big hits not only since 2022, but even in the month of September, have been suffered by the bond market and long-term yields have really gone up quite a lot since even just since mid summer, they've gone up at least 80 basis points, so 0.8%, and reaching levels that we haven't seen in Europe for the bond since 2009. For the U. S. Treasury, 10-year Treasury, we haven't seen today's level 5.3% since 2002. So we're really getting back to the levels of long-term interest rates that we saw really in the 1990s, aren't we? Now, you could argue that's a re-normalisation, but what are the key factors behind this move to re-normalise, particularly since March?
[Guy Ertz]: Well, that's very interesting because when you decompose the yield in the main components, i. e, the long-term inflation expectations and the real yield, you see that the long-term inflation expectations have not been moving that much, meaning that most of the move came from the real yield side. Now, in the real yield, we have to still decompose also a little bit further. There is obviously the demand for capital, which is reflecting basically long-term economic growth potential, and that has been the major driver.
Now, to what extent the market is probably exaggerating a bit, extrapolating the current boom in investment—that's something to discuss. And we think it's probably the case that the market exaggerates somewhat on that side. But the other component in that real yield could be linked to the fact that the issuer risk is rising somewhat. We know that, especially in the U.S. with high deficits, high debt, that could be an issue. It's probably partially explaining the move, but the big chunk of the move is really linked to the pure real yield component related to the demand for capital and the potential for economic growth. But once again, we think that probably also is a bit overestimated in terms of really long-term projections. So, in a nutshell, really what we think is that we are in an overshooting mode on the yield side.
So, obviously, we think that with current yields around three sixty in Germany, for example, and around five twenty five, five thirty in the U.S., we are with yield levels that seem quite high, and that could be at least on a twelve-month horizon falling back somewhat, especially in Europe, I would say. So, we have been revising up a bit our target for twelve months for yields. Typically, in Germany, we now have a yield target at three, but it remains considerably below the current levels of yield. So, that's one first important part.
The second on the U.S. side is that we have also here revised up a bit the target for the ten-year yield. We revised it from four fifty to four seventy five, but again, the current level is much higher. However, in the U.S., we could be pushing somewhat higher in the coming month, and we could even be moving beyond five fifty in the coming weeks. But that's really here, I would say, what differentiates a little bit from between the U.S. and Europe. Finally in the U.K we have also revised up the target for the ten-year government bond yield from 4.65, sorry, to from 4.40 to 4.65, and here we have also some overshooting with the current level much higher than that.
[Edmund Shing]: And I guess what we have potentially, I mean, I know investor sentiment towards bonds at the moment is pretty negative, reflecting, of course, the underperformance of bonds for most of this year. But I think you're right that there may be a little bit of too much pessimism around bonds at this level, and for conservative investors that has to provide an opportunity to lock in yields for the long term. Because as we know, over the long term, the expected return from bonds is usually equivalent, more or less, to the current starting yield. Of course, the starting yield is higher that means your expected return over the medium to long term is correspondingly higher as well. And if you're a conservative investor looking for a steady income stream, then you know you get a much better opportunity set today, whether you look at U.S, U.K. or eurozone bonds, than would have been the case earlier this year. So I think that's got to be interesting, hasn't it, Guy?
And also you can look not only at government bonds, but also you can look at other ways to enhance the yield on top of that in the U.S. with mortgage-backed bonds, or of course with investment-grade corporate bonds. And in Europe again, investment-grade corporates as well will add a spread on top. So you can even do somewhat better than the government yields you mentioned by maybe taking a little bit of corporate credit risk as well.
[Guy Ertz]: Yes. To summarise, really our highest convictions, really what we put forward is the long end, in particular of European yields, but with the focus on core eurozone. We also like, and that's what we upgrade this month. U.K. government bonds, so that’s the second interesting opportunity here. And then away from govies, we put the focus on eurozone corporate bonds, but really on the investment grade part because we're looking still to keep the focus on quality. So these are really the main parts, and in the euro, to the eurozone corporate bonds preference, we also added just added here yesterday in the flash also the corporate investment grade in the U.K.
[Edmund Shing]: Excellent. So quite a quite an interesting opportunity, particularly not only for U.S. dollar-based investors, but also for euro, European investors at this point. Thank you very much, Guy, and thank you to our listeners for tuning into this podcast. Please like, share, subscribe to our series of podcasts from BNP Paribas Wealth Management. And until the next time, thank