After the tariff turmoil of 2025, the consensus US economic forecast for 2026, according to Bloomberg, is for steady 2% GDP growth, further moderation in inflation and a relatively stable labour market. In this environment, we’d expect global bond markets to generate a steady mid-single-digit return, supported by the attractive level of starting yields. As a result, we continue to believe that maintaining diversified exposure to investment grade corporates, emerging market debt, securitised credit and agency mortgages can enhance income and boost potential returns.
Yield curve steepeners provide a robust upside risk hedge
Risks to fixed income returns are biased to the upside, with the possibility of double-digit returns in an environment where rising unemployment leads central bank to cut interest rates by more than is currently expected. Given this scenario, we believe that positioning portfolios to benefit from a steeper yield curve has the potential to produce above-market performance.
If we look at the difference between the two-year US Treasury yield and the 10-year US Treasury yield over the past 40 years (Exhibit 1), we can see that the slope of today’s yield curve, at around 68 basis points, is at similar levels to previous periods when the US economy slowed but avoided a recession, such as in 2019 and 1995-1997. However, as the shaded recession areas show, if rising unemployment results in deeper rate cuts we could see the two- to 10-year curve steepen by 150bps-250bps.
It’s this positive skew towards potential returns that makes a yield curve steepener strategy appealing for bond portfolios that are focused on enhancing income while managing risk. Historically, yield curve steepener strategies have also provided better risk-adjusted returns than simply adding duration, as shown by their higher information ratio. As a result, we believe yield curve steepeners offer a more robust risk hedge for portfolios in the current environment.
Differences in the slope of global curves create alpha opportunities
Global bond markets tend to be correlated because of the inter-linkages in the global economy. But differences in national economic cycles or valuations allow bond investors to achieve better returns by exploiting these differences in relative value.
If we look at the two- to 10-year yield curve slope of major developed markets (Exhibit 2), we can see that from a valuation perspective the differences in curvature are not large, with the US at the flatter end of the range and Japan at the steeper end. However, when we introduce economic fundamentals to the mix, we find that some markets begin to appear more attractive than others. In Australia, for example, rising inflation means there is a genuine prospect that interest rates could rise, causing the yield curve to flatten. In the US and the UK, by contrast, weak employment growth and rising unemployment means there is a risk that central banks may need to cut rates more aggressively, steepening yield curves in these markets.
Because these differences in economic fundamentals don’t appear to be properly reflected in valuations, holding yield curve steepeners in the US and UK, and flatteners in Australia appears an effective way to add alpha from relative value positioning.
Even bigger valuation discrepancies can be seen in global 10- to 30-year yield curves (Exhibit 3). The Japanese curve, in particular, stands out as very steep compared to its global peers. Some of this steepness reflects economic fundamentals, as the Bank of Japan normalises interest rates against the backdrop of a large government debt burden. Nevertheless, the contrast between the steepness of the Japanese 10- to 30-year curve and Japanese two- to 10-year curve suggests that a lot of the risk premia in the long-end of the Japanese market reflects technical factors. Holding JGB 10-30 flatteners is an attractive way to diversify the portfolio’s global steepener theme.
Conclusion:
In a world where steady US growth, softer inflation and modest cuts in US interest rates are expected to lead to solid single-digit returns from global fixed income, active portfolios can seek enhanced returns from a globally-diversified allocation to high quality non-government bonds. In the US, we believe holding yield curve steepeners provides an attractive way to hedge risk in portfolios that are underweight government bonds. Also, thanks to the differences in yield curve shape and economic fundamentals across different national bond markets, globally-diversified fixed income investors can also capitalise on alpha opportunities to enhance returns, without simply increasing beta.