Clockwise: Bond yields rising for economic, not political reasons

When central banks cut short-term interest rates, either due to economic weakness or disinflation, government bond yields usually move lower.

The Bank of England cut interest rates twice in 2024. Why then, are yields rising this time? We see economic rather than political reasons behind this trend and we continue to prefer stocks (and commodities) to bonds.

The Federal Reserve has cut interest rates on eight occasions over the last 40 years. Stocks generally did well in scenarios when the economy enjoyed a ‘soft landing’, but entered a bear market if the rate cuts presaged recession. Government bonds, however, always did well as rates were cut, whatever the backdrop (Table 1).

Table 1: Financial market behaviour during Federal Reserve easing cycles

Source: RLAM. Changes between first and last Fed rate cuts. Total returns in US dollars using S&P Composite index for stocks, 10-year US Treasuries for bonds and the GSCI index for commodities. Current instance as of 10 January 2025.

This time is different. The Fed has cut rates by a full percentage point. Yes, stocks are up, as you’d expect in a mid-cycle slowdown, but government bonds have been sold off aggressively, with 10-year treasury yields and gilt yields rising by around one percent.

Political commentators in the UK link the rise in yields to the Budget. But we think this is a global phenomenon, which we put it down to the major wrong-footing financial markets have suffered since September 2024. Back then, the overriding preoccupation was the risk of a US recession, and the markets were pricing in 10 quarter-point rate cuts. We’ve seen four to date, but with Trump heading back to the White House and US economic data strong, investors now think there are only one or two left.

Chart 1: The Investment Clock is in Reflation but moving towards Overheat

Source: RLAM. For illustrative purposes. The trail and yellow dot signify the momentum of global growth and inflation based on RLAM’s proprietary scorecard indicators over the last 12 months.

Some forecasters are already talking about rate increases. Indeed, the Investment Clock model that guides our asset allocation is picking up signs of both stronger growth and higher inflation. It’s not beyond the realms of possibility that we move into Overheat in 2025, echoing the 1998/9 experience, which saw rate cuts quickly turn into hikes. In this scenario, as in 1999, strong earnings growth would probably still see stocks beating bonds – at least until higher interest rates took effect.

We are living in very uncertain times. It’s also quite possible that Trump’s promised tariffs increases and the deportation of undocumented migrants dent US growth and snuff out a fragile global recovery. As active investors, we need to take one step at a time. For now, we see the economic rationale for higher bond yields, but we stand ready to sell stocks and buy bonds if the world economy takes a turn for the worse. In our view, with yields back to more normal levels, government bonds are no longer ‘return-free risk’, and diversification makes sense.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.