Payden & Rygel: Inflation, interest rates and duration
By Paul Saint-Pasteur, Global Fixed Income Portfolio Manager at Payden & Rygel
Both the ECB and the Fed are on hold. Is this a pause set to last or could rates start moving again in the coming months?
Inflation has surprised to the upside on the back of a combination of factors — energy, AI-related demand, tariffs and more resilient growth — pushing both central banks to pause.
The ECB has raised rates once and will probably do so again in September, with further moves tied to how long the conflict in the Middle East lasts and to any second-round effects.
The Fed is weighing a different set of factors (more tariffs and AI demand, less energy), as well as the new Chair's strategy. The next move will likely hinge on consumer inflation data, with the bar for a hike now lower than it was at the start of the year.
Can rising energy prices slow the fall in inflation and keep rates higher for longer?
Rising energy prices feed directly into headline inflation. Central banks tend to 'look through' these shocks, as they reflect a one-off change in relative prices rather than persistent demand pressure.
That said, if the increase in energy costs were to prove long-lasting or particularly large, it could generate second-round effects. In that scenario, higher energy prices could keep rates elevated for longer — through higher rate expectations, more persistent inflation or, in the case of the Fed or the ECB, actual further rate hikes.
With steeper curves, is it better to stay short or start extending duration?
The answer depends on how the curve evolves relative to what the market has already priced in. Right now curves are not especially steep: the spread between 30-year and 2-year German Bund yields is around 85 basis points, a modest premium for a duration ten times longer.
We expect further curve steepening over the coming months, driven by higher bond supply, underappreciated fiscal risks, persistent inflation expectations and a gradual normalisation of the term premium after years of central-bank balance-sheet support. We prefer to stay in the short and intermediate part of the curve, avoiding the long end for now.
Is the rise in long-term yields temporary, or does it signal a structural shift in the market?
The rise in yields is driven above all by higher real yields and by a higher premium investors demand on longer maturities, with inflation expectations broadly anchored. This combination reflects both structural factors — vulnerability to future supply shocks, deficit sustainability — and cyclical dynamics, in particular corporate issuance linked to AI investment competing with US Treasuries for available capital. Growing investor uncertainty over the Fed's reaction function and its independence is also weighing on the market.
Does the increase in public issuance for defence and infrastructure risk keeping government yields high?
Yes, it is one of the factors to consider: greater net supply of long-dated bonds, while central banks continue to shrink their balance sheets, implies a structurally higher risk premium demanded by investors. This is happening as supply from corporate credit issuers also rises, where growing long-dated issuance is reshaping the balance between supply and demand.
With credit spreads still compressed, do coupons really compensate for the risk, especially in high yield?
Only in part. The high yield credit sector enters August with an OAS of 281 bps, in the tightest decile of its history against a long-term median close to 450 bps. We believe this compressed spread can still represent a decent return over the coming months, with coupon income as the main component. However, a 100 bps widening could wipe out more than a year of carry: the asymmetry is less favourable, as there is more room for spreads to widen than to tighten further.
Which fixed income segments offer the best opportunities today, and which carry the greatest risks?
Carry is likely to remain the main driver of excess returns. With credit valuations on the more expensive side of historical ranges and curves relatively flat, we prefer credit risk to duration risk at longer maturities, favouring sectors that offer investors greater protection. The boom in AI-related issuance also calls for strong discipline in security selection.
We see the best opportunities in hard-currency emerging markets — particularly in the corporate segment — and in securitized assets, such as euro-denominated CLOs and dollar- and euro-denominated ABS. We keep limited exposure to long-dated fixed income, where spreads are particularly compressed, such as IG corporates, and to lower-rated assets such as B or CCC.
