By Yoruk Bahceli

(Reuters) – The U.S. government bond market has just posted its best week performance since March 1, suggesting that a steep rise in yields caused by high inflation might finally be fading as growth worries take center stage.

The Bank of England had warned of possible recession in Britain and Gilts saw the best performance they have seen since 2011.

The central banks are just starting to tighten their policy, and the inflation rate remains high. There is reason to be cautious.

These four major shifts suggest that the global largest debt markets are at a crossroads.

1/ NO CONVICTION

The benchmark 10 year bond yields for U.S. Treasuries have fallen below critical levels. They were 3%, 2% and 1% respectively on British gilts.

“The fact we didn’t hold on to that was taken by ING senior rates strategist Antoine Bouvet as a sign that…there wasn’t that much conviction behind yields,” he said.

BofA reported that underweight U.S. bonds are being covered by investors. This is due to the rate swings. The levels were last observed in early 2021. Short positioning on rates, which is betting that yields will rise even further, was deemed the most popular trade by respondents.

2 PEAK INFLATION

Since the U.S. Federal Reserve increased rates in May 4, market inflation expectations fell particularly quickly.

The difference in nominal and inflation adjusted yields is called inflation breakevens. This was further evidenced by U.S. data.

After being over 3% in March, the U.S. 10-year breakeven rate has fallen to 2.7%. This week, it has fallen 20 basis points. It is the steepest weekly drop since April 2020.

At around 2.16, the eurozone’s five-year-old, five-year-breakeven forward inflation swap was at its lowest level in two months.

Inflation-adjusted, real yields have driven these falls. The U.S. 10 year real yields have increased 25 bps in the past two weeks. Germany’s equivalents are up 43 Bp.

The U.S. inflation linked bonds (TIPS), which provide a critical hedge against future inflation, saw outflows in the last three week according to BofA using EPFR data.

Arne Perezas, senior analyst with AFS Group, stated that if markets are correct, central banks’ inflation problems will be less severe than they were weeks ago or months ago.

Graphic: U.S., euro inflation breakevens fall-https://fingfx.thomsonreuters.com/gfx/mkt/gkplgkrqbvb/breakevens.png

3. LOWER TERMINAL RATES

Markets have decreased their bets on “terminal rate”, the point at which this hike cycle will end, as inflation expectations are falling. Investors believe that fewer hikes are necessary in order to control inflation.

Money markets in America suggest that interest rates will rise by around 3% between mid-2023 and 3.5% early in May. Economists in the Euro zone have expressed concern about the excessive rate hike pricing and the ECB has lowered its policy rate to 1.2% for 2024.

“The huge move in bond prices has been accompanied with a reiteration of rates outlook for Fed, Bank of England, and ECB,” said Divyang Shaikh, strategist at Refinitiv’s IFR Markets.

It is “very different from previous corrections to bonds that didn’t last, as the expectations were still increasing.”

Graphic: ECB rate hike bets- https://fingfx.thomsonreuters.com/gfx/mkt/mypmnydqavr/ECB%20pricing.PNG

4/ SAFE HAVEN

Last but not least, the stellar performance of this week’s bond market was accompanied by a 4% drop in world stocks. This put top-rated government bonds back into safe-haven.

This inverse correlation was absent in recent years as bond and equity prices plummeted together due to rising inflation.

The United States is experiencing the first week of March, when 10-year bonds and the will end in the opposite direction.

Nick Hays of AXA Investment Managers’ sterling rate and credit division said, “The thing that hasn’t been missing is risk-off means that bonds rally.” While it doesn’t work every time, we cannot ignore the fact that bonds aren’t a safe haven.

Graphic: Treasuries vs S&P500-https://fingfx.thomsonreuters.com/gfx/mkt/gdpzyazjavw/sp%20vs%20usts.png