Fixed-income investors have earned strong returns since October, as the market anticipated rate cuts and pushed down bond yields. We agree that policy rates are likely to fall this year but think investors may be expecting too much from central bankers and end up disappointed. While the 4% yield on the 10-year Treasury is attractive, the gains of recent months mean that the prospect of outsize returns has dimmed since the last Global Investment Outlook. At that time, we highlighted good odds of mid-to-high single-digit returns for bonds, and a decent chance of double-digit returns. We now expect a mid-single-digit return for holders of government bonds over the next year. Our view is that the slowdown in inflation will likely continue and that looser labour markets will permit some central-bank easing, likely leading to a decline in bond yields over the year ahead.
To be sure, the potential returns from bonds remain compelling. The most important part of this calculus is simply that yields are high, and high yields provide a better jumping-off point for returns. If yields are unchanged a year from now, investors can expect to receive returns of 4.1% on their bond holdings. The higher starting yield provides a cushion if bond prices retreat. For instance, a 1.00% rise in yields would result in losses of 3.0%. They also provide a springboard for returns if yields were to fall: the same 1.00% decline in yields would produce gains of 11.9% (Exhibit 1).
Exhibit 1: Bonds can offer solid returns for investors
Note: 1-year return for U.S. 10-year government bond from February 29, 2024 to February 28, 2025. Source: Bloomberg, RBC GAM calculations
The threat of runaway inflation, which we believe linked bond and stock returns closely since the pandemic, is also much lower, a scenario that tends to favour fixed income. In many economies, the pace of price rises has dropped to levels not far from central-bank targets near 2% (Exhibit 2). The global decline in inflation, which in the U.S. was the fastest 12-month drop since 1990, speaks to the degree to which price pressures were likely transitory and tied to supply-chain problems and energy costs rather than excess demand. To be sure, recent attacks on oil tankers in the Red Sea and Russia’s control of a significant slice of energy reserves mean there is an elevated risk that energy prices could start rising again. Robust wage growth is also often cited as a reason why inflation could remain higher, but we think current wage demands mostly reflect past inflation rather than expectations of a reacceleration in prices. As inflation cools, so will wages. Against this backdrop, we think central banks have room to cut rates and bond yields could fall.
The biggest risk to our outlook is that the worst of the effects of global monetary tightening are behind us, and that the economy starts to accelerate. In fact, RBC GAM no longer expects a recession this year, and has shifted to a base case forecast of modest growth. In this scenario, the U.S. economy remains positive and growth in the economies of America’s developed-market peers starts to catch up.
Governments, moreover, continue to keep spending, propelled by increasing budget deficits. Markets haven’t seemed perturbed by growing debt aside from a period of about three months starting in August 2023, when fiscal concerns led to a significant bond sell-off. Even with yawning deficits, we think it is unwise to expect a significant curtailment of government spending in 2024 as so many countries face elections, not least the U.S. For now, higher fiscal deficits remain a risk that could exacerbate a sell-off in bonds, rather than a principal cause. Over time, rising debt will cause a greater and greater share of government revenues to be devoted to debt servicing, reducing the flexibility of governments to support spending. We believe this is an issue that will need to be addressed.
Exhibit 2: Inflation is much lower everywhere
Note: Inflation rates adjusted for regional calculation differences. Source: Bloomberg, RBC GAM, National statistical offices
United States
The U.S. economy continues to defy expectations of recession. The significant decline in bond yields, rising prices for stocks, cooling inflation, strong government spending and rising wages are a powerful combination supporting economic activity to start 2024. However, we are unconvinced that growth can be sustained at these levels. However, we believe that a slowdown is likely over the next 12 months given our view that the significant monetary tightening delivered since 2022 will eventually curb the expansion. Moreover, the pent-up savings built during the pandemic and government spending are likely to wane. High interest costs are already weighing on the housing market and business investment, and we believe they will at some point translate into higher unemployment and a recession. While consumer prices rose at a pace modestly above the U.S. Federal Reserve’s (Fed) target of 2% over the past year, they are up just 1% during the past three to six months. We think, therefore, that the Fed is keen to ease policy from current levels, which it believes are restrictive for economic activity. Our forecast is that the target range for the fed funds rate will decline to between 4.00% and 4.25% from the current 5.25% to 5.50% over the next 12 months, with cuts beginning in the second half of 2024. We expect U.S. Treasury yields to fall too, with the 10-year bond yield declining to 4.00% over the next year from around 4.30% at the time of writing.
Eurozone
The eurozone economy, in contrast to the U.S., is barely growing. Over the past year, the single-currency area’s GDP has expanded by just 0.1%, its worse annual reading since the depths of the region’s sovereign-debt crisis in the early 2010s (excluding COVID). Inflation has been much more persistent than in the U.S., too, leading us to believe that stagflation risks are higher in the eurozone.
The eurozone’s economic infirmities, however, disguise important divergences among its member countries. Germany, without a doubt, has struggled with much higher energy costs and muted demand from China. In contrast, Spain and Italy have posted strong growth and their labour markets remain tight. We believe these countries share a similar story with the U.S., where fiscal largesse has bolstered growth. In Europe, though, it has been the EU itself opening the spending taps to fund various Europe-wide projects, rather than central governments. Italy and Spain have received huge sums as a percentage of GDP, while Germany has received little since it is judged to be relatively wealthy. The different needs of the economies it oversees as a central bank raise a perennial problem for the European Central Bank (ECB) and suggest very different policy prescriptions.
Wage growth in Europe has likely peaked but remains much too high at between 4% and 5%. Now that inflation has cooled, we expect demands for higher wages to cool also. With high rates of unionized workers, we know that several high-profile negotiations are taking place this spring. We believe that the ECB is unlikely to cut policy rates without greater confidence that the slowdown in price pressures is also being reflected in wage expectations. Ultimately, we think a cooling economy and slowing inflation will prompt the ECB to begin cutting rates later this year – with the deposit rate falling from 4.00% now to 2.25% in a year’s time. German 10-year government-bond yields already reflect much of the expected decline in policy rates, and we expect them to be about the same in a year, at 2.35%.
Japan
We believe that Japan is experiencing the most profound increase in price pressures in several decades. Prices for items that serve as important reference points for consumers, such as that staple bowl of ramen, have risen sharply – after remaining unchanged for years. It is probable that Japanese workers will enjoy the strongest wage growth in the G7 group of developed nations.
The Bank of Japan (BOJ) has signalled its intent to make policy more restrictive by permitting government bond yields to rise, and we think further normalization is likely this year. The BOJ’s policy rate could rise above zero for the first time since 2016. We forecast the benchmark interest rate at 0.10% sometime over the next 12 months. Meanwhile, we also expect bond yields to rise, with the yield on the 10-year Japanese government bond reaching 1.00% in the year ahead.
Canada
The Bank of Canada (BOC) left its policy rate unchanged at 5.00% in March, marking the fifth consecutive meeting that policymakers kept rates on hold. The BOC remains hesitant to lower rates, even after the annual pace of inflation fell to 2.9% in January 2024 from as high as 8.1% in June 2022 amid weakening economic growth. Policymakers said they consider policy rates to be sufficiently tight to keep inflation in check, but patience is required as the economy has done better than expected thanks largely to immigration. However, the unemployment rate has risen by 0.8 percentage point since 2022, and Canada’s economy is expanding more slowly than the pool of workers is rising. In per-person terms, Canada’s economy has shrunk markedly over the past few years, and, in a rare and disconcerting development, Canadian productivity is declining. The BOC has nothing in its arsenal to directly effect structural changes that would boost productivity. Nor does it control immigration, and it can’t build houses. In fact, the BOC’s efforts to cool inflation via higher policy rates are now the largest contributor to inflation - via soaring mortgage costs and rents. We expect these circumstances to sway the BOC toward earlier rather than later cuts as long as inflation continues to cool towards 2%. If progress toward 2% inflation is better than the BOC expects, policymakers would likely cut interest rates more than our forecast.
United Kingdom
The UK ended 2023 in recession, as the economy shrank in consecutive quarters. Domestic activity was poor, as businesses reckoned with cooling demand from households and rising prices. Inflation is double the Bank of England’s (BOE) target of 2%, with consumer prices rising by 4% year over year in January. Inflation in service industries exceeds 6%, reflecting heady wage gains for employees. High rates of inflation mean that the BOE has been slow to consider easing policy rates. At least some of the economy’s persistent weakness is related to a hangover from leaving the EU in early 2020, when the UK lost access to its main trading partners, and the resulting malaise is something that monetary policy will be limited in addressing. We think economic conditions will continue to deteriorate over the next year, leading to a weaker labour market and slower wage gains. We believe inflation will cool enough for the BOE to cut its policy rate to 4.25% from the current 5.25% sometime over the next 12 months. We think the UK’s long-run economic prospects are among the worst in the developed world, and that the country will likely experience persistently higher inflation and poorer growth than its peers, exacerbated by the questionable competence of its political class. These concerns should keep gilt yields from falling as much as might be expected in an environment of declining policy rates. We forecast the 10-year gilt yield at 4.00% over the next year, only slightly lower than the 4.10% they are at now.
Regional outlook
We are overweight U.S. government bonds and underweight Japanese government bonds. We believe high starting yields and the prospect of rate cuts over the next 12 months in the U.S. likely mean that Treasuries will outperform their Japanese counterparts. In contrast, we expect policy tightening from the Bank of Japan, likely boosting bond yields and leading to relatively disappointing returns.