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00:00 Patrick

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. 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. Lucile, thanks for finding time on a busy day in markets to join me in the studio.

00:44 Lucile

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.

00:52 Patrick

Well, let's start with the 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?

01:04 Lucile

Sure. So the sell off initially started, you know, alongside the war in in Iran. And that's essentially a function of inflation expectations from higher energy prices. And also you know what any secondary effects would be from those higher energy prices and higher kind of headline inflation. More recently, the region 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, you know, those, are essentially political in nature in the UK. And I'd say a shift in, longer term neutral rates in, in the US.

01:51 Patrick

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?

02:05 Lucile

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, that market view, because they came out essentially focused entirely on the inflationary impact of the war in Iran.

02:32 Patrick

And that's when markets started pricing in quite aggressive hiking.

02:35 Lucile

Yeah, 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 EC is going to hike aggressively in, 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. So you're pricing less of an extreme scenario that you know the ECB with that need to reverse quite drastically a year later.

03:18 Patrick

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. You know, 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.

03:46 Lucile

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 predominately, more recently, like you pointed out. There is 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 gilt market. And for that reason, although, you know, you've had the front end reprice cheaper in sympathy with kind of re-escalation rate risk in the Middle East. The flattening has been somewhat mitigated by this increased risk premium that the gilt market needs to price in the long end as a result of the political uncertainty.

04:42 Patrick

Yeah. So your clients and, your colleagues presumably are looking for any little hints, any tidbits from potential candidates for that Labour leadership and thinking about what that would mean in terms of the fiscal outlook for the UK?

04:55 Lucile

That's exactly right. That's particularly relevant for the long end of the curve.

04:58 Patrick

What about, short term? 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 standing. What's the expectation around what might happen, in that June meeting?

05:16 Lucile

Yeah. So it's a really interesting question. And it's actually a point that, Jack Meaning, 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.

05:34 Patrick

Yeah. So lots to watch there in the UK. And I suspect we're 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?

06:00 Lucile 

Yeah, the US has been really interesting. You know, before the war broke out, the focus was really on AI and what that meant for the labour 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, you know, but on the labour side and labour impact of AI, the consensus view was essentially that, it was a replacement for labour.

And so the market was looking out for, you know, the labour 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 labour market has been stuck in this low hire, low fire environment. And there is an argument that the you know, the break even job growth rate is lower just because there's, you know, no immigration at this point in time.

And and so the market focus has shifted from, you know, concerns around the labour market as a result of AI to whether actually we're in this environment where the break even rate is lower and therefore potentially a terminal, you know, neutral rate is higher. So potentially we're not in at restrictive levels, here now. And so, you know, that coincided with re escalation in the Middle East.

And that allowed for the US 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 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. It talks about US 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.

08:09 Patrick

Yeah I'm sure I bet your clients are also talking about this - which is what was stop this selloff in the global bond yields? What's the catalyst that's going to bring yields meaningfully lower again? I'm sure you about say the Strait of Hormuz. But is there anything else that you know could change things?

08:25 Lucile

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 normalise in the Middle East, we need to have - 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. I think that would then help contain long end yields.

09:03 Patrick

Okay. And, when you put it all together and I know you look globally at all of this, we haven't even talked about Japan today - we've had no time. But its 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?

09:25 Lucile

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. And essentially because that's because 2 year 2 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, you know, we've talked about at length, specifically in the next June MPC meeting. You know, there's still eight basis points priced. And, you know, we talked about why we think it's unlikely that we get a rate move at that point in time.

10:20 Patrick

That is going to be a very interesting day in June. Look at Ford, see what happens there. And Lucille, thanks a lot for joining. It's been great to have you, on a busy day, Marcus.

10:29 Lucile

Thanks for having me.

10:30 Patrick

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.

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.