While the nominal US Treasury curve remains flat relative to even recent history, the US real yield curve is now markedly upward-sloping. This means that longer-dated treasury inflation-protected securities (TIPS) are offering a higher yield than shorter-dated TIPS, rewarding investors for taking on duration. In the event of a significant equity market sell-off, government bonds tend to appreciate and investors are likely to benefit more by holding longer-duration bonds.
The combination of the shift away from the flat TIPS curve, which characterised most of last year, and some of the factors underlying this shift, give pause for thought on US curve positioning.
Why the change? Attention has shifted to the combined impact of tariffs and a tighter approach to immigration. In the near term, these act as a direct supply shock to the US, reducing supply of labour and goods.
Over time, they also erode domestic demand: tariffs are, after all, a tax on the US consumer and as such reduce the purchasing power of their incomes.
This is before considering the impact of an additional and indirect channel weighing on the US economy: uncertainty. The on-off nature of tariff implementation in the lead up to and subsequent launch of ‘Liberation Day’, combined with the impact of the Department of Government Efficiency’s (DOGE) initiatives – for example, cuts to government jobs and termination of government contracts – have begun to weigh on sentiment, which, at the margin, weakens consumer spending and business investment.
The result is an economy that operates at a lower level of growth and higher level of inflation. This is what markets have started to price in: elevated inflation expectations are driving a wedge between the front end of the US nominal and real curves, creating an upward sloping real curve.
The combination of an upward sloping real curve and a weaker US domestic outlook has driven two changes to our positioning.
First, we have departed from the barbell position that suited a flatter real yield curve environment. Instead, we are now emphasising the belly (seven to 10 years) in our positioning, which is where the gradient is steepest. This allows for the greatest ‘roll down’ benefit to yields as bonds in this area of the curve move closer to maturity.
Secondly, we now prefer longer duration to give greater interest rate sensitivity against a backdrop of increased probability of a slowdown.
Closer to home, there is one final development which warrants mentioning: the extent of the movement in the UK real yield (index-linked gilt) curve.
A combination of factors – ’higher for longer’ inflation and short-term interest rates, concerns around the UK government’s fiscal position (both its ongoing impact on the supply of gilts and the potential for continued stimulative fiscal policy to create structurally higher inflation) and the diminishing role of defined benefit pension funds and liability-driven investment strategies as price insensitive buyers – has seen 20-year UK real yields reach 2%.
For a sterling-denominated investor, the long-term real yield differential between US and UK yields is now historically narrow, without the US dollar currency volatility. As a consequence, we have continued to increase our allocation to index-linked gilts and lengthen duration in our portfolios in response to better values.
US vs. UK 20-year real yields (%)
Sources: Bloomberg Finance, CG Asset Management
As the chart above shows, the gap between long-term real yields in the US and UK has narrowed considerably. This is a meaningful shift in relative value, suggesting that index-linked gilts should have a greater allocation in sterling multi-asset portfolios.
Of course, higher government bond yields are not necessarily a free lunch. To take a live, and very recent example: the ongoing battle between the chancellor and the gilt markets in respect of the credibility of the government’s commitment to the fiscal rules has become self-fulfilling. As market participants lose belief in the credibility of the commitment, gilt yields begin to rise, which in turn makes the fiscal rules harder to meet.
As such, there is always the possibility that good values today become better values tomorrow. However, stepping back from short-term changes in sentiment to take a more fundamentals-driven view, long-term UK real yields, which now offer a return of c. 2% over inflation, are elevated relative to recent years and relative to all estimates of the trend growth rate of the economy.
We believe that this change in value – both in absolute terms and relative to other major economies – demands even greater consideration in UK multi-asset portfolios.
Emma Moriarty is a portfolio manager at CG Asset Management. The views expressed above should not be taken as investment advice.