Financial markets are currently characterised by a foreseeable development towards structurally higher interest rates and increased volatility. Against this backdrop, participating in the yield chase that defined the post-global financial crisis era seems less opportune. Real yields on short-term securities were historically low, or even negative, for a long period, extending into the pandemic. Meanwhile, short-dated bonds offer positive real yields, enabling investors to hedge purchasing power and reducing the volatilities associated with longer-dated securities.
Broad exposure to the entire bond universe is often considered sufficiently diversified, in terms of both duration and credit risk. However, this assumption overlooks that the Bloomberg US Aggregate Index (Agg) consists of over 90 per cent US government bonds, corporate bonds, and agency mortgage-backed securities. Each of these segments is highly exposed to interest rate risk. This concentration, combined with the Agg's current duration of 5.89 years, argues against broad, passive index exposure, especially for players anticipating a deterioration at the long end of global yield curves.
As early as the beginning of 2026, an inflation shock demonstrated how central banks with a primary mandate for price stability can be forced into a more restrictive monetary policy. Although military conflicts in the Middle East have largely subsided, a lasting ceasefire is not guaranteed due to ongoing tensions. Even with unrestricted passage through the Strait of Hormuz, the full restoration of regional energy infrastructure will take months. Energy markets are subsequently likely to set higher prices for hydrocarbons from the Middle East, reflecting the changed regional dynamics. This implies a longer period of higher energy prices than many market observers anticipate.
Concurrently, Europe continues to face elevated energy prices due to the conflict in Ukraine. While energy import-dependent regions struggle with supply-driven inflation, US monetary policy must offset unexpectedly robust economic growth. Expectations for multiple interest rate cuts have been revised; consensus now leans towards prolonged stability or even one to two interest rate hikes in the coming quarters. The need for tighter monetary policy is often underestimated in this discussion. Monetary policy operates via the credit channel, and historically low credit spreads coupled with double-digit corporate earnings in recent years suggest that companies are hardly suffering from a shortage of capital. At a macro level, indicators such as the low point of the Fed's inflation indicator in April 2025, a low unemployment rate, and strong US consumer spending, signal that interest rates should be higher.
An additional factor is the potential inflationary effect of Artificial Intelligence (AI). The expansion of AI infrastructure requires enormous resources, from building materials and labour to the electricity consumption for data centres. A restrictive immigration policy could also intensify competition for skilled workers and fuel wage-related inflation beyond the AI ecosystem. Although the direct impact on consumers is still unclear, the far-reaching implications could prompt the Fed to keep its policy rate near current levels. The deflationary effects of anticipated productivity gains from AI remain to be seen; however, they could dampen long-term inflationary forces. AI could also impact bond markets, as record emissions are required to finance the expansion, which, combined with maturing legacy bonds, could lead to rising yields across the fixed-income market.
Investors will likely continue to rely on fixed-income securities to ensure capital preservation, stable income generation, diversification against riskier assets, and low volatility. Given the emerging economic and market environment over the next few years, however, investors should seriously consider focusing on shorter-dated securities to achieve these goals and address concerns about concentration at the short end.
