Countries that moved quickly to address this year's inflation surge are winning favor with bond investors, while slow-acting economies may pay the price through higher interest rates.

Asset managers including Jupiter Asset Management and Colonial First State are buying Australian government bonds, betting that the country's four rate hikes since February mean the tightening cycle is nearing its end.

Institutions such as UBS Asset Management and Carmignac are increasing their holdings of German government bonds. They believe the European Central Bank has responded more proactively and can better manage inflation pressures compared to the Federal Reserve and the Bank of England, meaning German bund yields are likely to decline.

The underlying logic is that central banks that act earlier will see policy effects sooner, leaving limited room for further tightening. This contrasts with the inflation shock of 2021 to 2022, when central banks initially stayed put and then raised rates sharply in unison. This year, the pace of policy adjustments across countries has been uneven, creating opportunities for investors to bet on divergent trends.

"The core theme this year is inflation and central bank credibility," said Mark Nash, fixed income fund manager at Jupiter Asset Management. "Economies that respond appropriately will benefit."

Monetary policy has lagged effects, and the ECB's tightening has not yet fully transmitted to the real economy, which is one reason European inflation remains stubbornly high. Reserve Bank of Australia Governor Michele Bullock said Tuesday that the full effects of rate hikes take 12 to 18 months to materialize.

The ECB's policy stance is the core reason Carmignac increased its holdings of 5-year German government bonds, preferring German bunds over other developed-market bonds. In recent months, ECB policy has driven the German yield curve flatter compared to other G10 countries, signaling declining long-term inflation expectations.

"I distinguish between central banks, with the ECB on one side and the Fed and Bank of Japan on the other," said Guillaume Rigeade, co-head of fixed income at the French asset manager. "The ECB made its position clear in March and April this year: 'This is an inflation shock.'"

ECB President Christine Lagarde said this week that rising government bond yields will drag on economic growth and dampen the inflation impact of higher energy costs, by more than the bank estimated at its second rate hike last month. Policymakers need to anticipate second-round inflation effects as much as possible, "because by the time it shows up, it is often too late."

'Catch-up' rate hikes

Kevin Zhao at UBS Asset Management is buying both 30-year German government bonds and Australian government bonds. His logic is that central banks that started raising rates earlier will not need to tighten policy significantly later. At the same time, he is shorting U.S. Treasuries, reasoning that artificial intelligence is boosting the U.S. economy and the Fed will need to conduct more rate hikes.

"When facing a supply shock, central banks proactively tightening policy is beneficial for bond investment, as it reduces the risk of inflation spiraling out of control," Zhao said.

Rufaro Chiriseri at RBC Wealth Management said: "A 30-year Treasury yield reaching 6% is not entirely impossible."

With this week's rate hike, the RBA became the first major central bank to raise rates above their pandemic-era highs. Bullock expressed hope that this year's four rate hikes will be sufficient to suppress inflation, and Australian bonds subsequently rallied.

Jupiter's Mark Nash has overweighted Australian bonds across all his fixed income funds. After the RBA signaled the tightening cycle is nearing its end, he reduced yield curve flattening positions this week and shifted to holding 2-year bonds. He had been cautiously buying U.S. Treasuries, judging that the Fed would be slower to follow Australia and Europe. However, this month's Treasury selloff pushed 2-year yields to a more than two-year high, and he began entering the market, believing the market is pricing in too high a probability of rate hikes in coming months.

Jamie Niven, senior fixed income portfolio manager at Colonial First State, favors Australian bonds even more, prioritizing them over New Zealand and U.S. bonds. He also reduced exposure to UK gilts, reasoning that the Bank of England has yet to raise rates and will be forced to catch up in the future.