Insights
Can the Fed Take Home a Gold?
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Global Fixed Income Bulletin
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August 12, 2024
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Can the Fed Take Home a Gold?
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August 12, 2024
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Can the Fed Take Home a Gold?
Can the Fed Take Home a Gold? |
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July was another consecutive month of strong returns for fixed income investors. Government bond yields fell as the inflation picture improved across most of the world, economic data continued to come in at or around expectations, and the rhetoric about central banks beginning their easing cycles picked up. The U.S. 10-year treasury fell 37 basis points (bps) over the month and the 2s10s curve steepened by 13bps. Similar themes were seen amongst much of the developed and emerging markets. Investment grade credit spreads continued to grind tighter with the Euro-area outperforming the U.S., while the high yield markets experienced marginal spread widening over the month. EM external and EM corporate spreads also widened. Within FX markets, the dollar fell 1.7% vs a basket of other currencies, most notably versus the yen as the currency appreciated 7.3% versus the dollar over the month as the Bank of Japan raised its policy rate to 0.25%.
Fixed Income Outlook
July saw a continuation of the recent positive performance in fixed income. Government bonds continued to rally as both inflation and activity data affirmed the view that central banks would soon cut rates and do so more quickly than previously expected. Economic activity continued to slow gradually from a high base, thus giving central bankers room to dial back the level of policy restriction. Curves also steepened towards the end of the month; as investors not only expected more and quicker cuts by central banks, but also began to reconsider the outlook for fiscal policy and public deficits – particularly in the U.S.
On the back of recent data, U.S. Treasury yields have continued to move meaningfully lower. July’s economic releases continued to paint a picture of cooling inflation, thus giving the Fed room to focus on the second of its two mandates – employment. To that end, markets have become sensitized to signs of weakness in the labor market, seeing softening there as a possible catalyst for more easing. Faster-moving indicators like the unemployment rate are modestly increasing, even though labor market data and business surveys are continuing to point to trend-like growth of about 2% in 2024. The economy is still creating well over 100,000 jobs per month, though one important caveat is that large-scale immigration into the U.S. over the past two years has complicated the task of interpreting data.
The Fed, which has stayed the course on data dependence this cycle, is finally starting to see data that should justify its change in stance. Outside the U.S., however, many central banks have already started to lower rates, including the Swiss National Bank, Riksbank, Bank of Canada and European Central Bank. Just as for the Fed, the most important question pertains to how quick and deep their cutting cycles will be. The information we have at hand suggests they will proceed cautiously, with services inflation and wage growth remaining elevated in regions like the UK and Eurozone. Recent upside surprises in realized inflation in Canada and the Eurozone also suggest inflationary risks remain.
Despite central bank’s reluctance to pre-commit to policy paths, bond investors’ optimism about future policy has increased. Cuts are now almost fully priced for each of the September, November, and December FOMC meetings, as well as one cut per quarter in 2025. The ECB, meanwhile, is priced for over two more cuts this year and almost six cuts to the end of 2025. While the aforementioned scenarios are certainly not impossible, an aggressive easing cycle would be contingent on activity data slowing and pointing to a deep recession.
Going forward, much is still unclear about the depth and pace of the global easing cycle. While bonds can continue to perform well in the near term, we remain cognizant that a sustained rally would require a material slowing of activity data to suggest a recession, and central banks globally to move away from the conservative approach they have embraced so far. Longer term, the level that U.S. and Global 10-year yields will go depends on the extent of the easing cycle.
Just as was the case in June, markets were confronted with political surprises in July in the form of the assassination attempt on Republican Nominee, Donald Trump, and President Biden’s subsequent withdrawal from the race. While the former event led markets to price in a much higher probability of a Republican-dominated Congress, Vice President Harris’ candidacy has made the race closer. Although, there is some uncertainty as to her likely policy platform. As before, we believe the situation warrants monitoring, and we remain alert for new information that could change our outlook.
Regarding credit, we continue to view credit spreads as fairly priced, and although they may appear rich by historical standards, we do not believe they are expensive to fundamentals. There is no reason to believe spreads will materially widen when economic growth is decent (and coming in around expectations) and central banks are beginning to engage in a modest rate cutting cycle. Yield-oriented buying should contain spread widening, but one factor we are paying close attention to is the level of all-in yields and their impact on demand for corporate bonds. It is possible that if yields fall further, buyer demand could begin to wane, and spreads could widen, especially under a rising recession probability scenario. This risk is offset, however, by central banks’ rate cutting bias which should serve to truncate spread widening risk. We remain modestly overweight credit in portfolios.
Emerging market (EM) local market returns were varied, with positive returns from duration but mixed currency returns. In Asia, Fed-sensitive central banks look more likely to be able to ease policy soon, given increased certainty about a Fed cut that has also lifted pressure on local exchange rates. In Latin America, government bond yields also fell, but a few currencies – such as the Brazilian Real and Mexican Peso – were materially affected by the unwinding of carry trades in the second half of July. We remain focused on idiosyncratic opportunities that feature favorable risk/reward characteristics.
Given global economic and policy uncertainty, we continue to find the best fixed income opportunities in shorter maturity (0-5 years) securitized credit, such as residential mortgage-backed securities (RMBS), asset backed securities (ABS), and selective non-office commercial mortgage-backed securities (CMBS), given their higher yields and strong collateral. U.S. households with prime credit ratings have strong balance sheets, and this should continue to be supportive of consumer credit and ancillary structures, especially as house prices remain firm. U.S. agency mortgages still have value compared to investment grade credit, at least in higher coupons, and they should outperform U.S. Treasuries.
In currency markets, the outlook for the U.S. dollar remains uncertain. July saw the dollar weaken against peers as yield differentials narrowed. Convergence of the U.S. economy towards global averages, as well as imminent Fed cuts, should exert some downward pressure on the dollar, notwithstanding a resurgence in recessionary fears that would prompt a flight to safe assets. As of now, however, it remains unclear who will inherit the position of global growth leader. Europe and China are seeing lackluster cyclical data in addition to grappling with structural woes. Emerging markets continue to be confronted with idiosyncratic challenges (as well as opportunities). In the middle of the month, carry trades began to unwind owing to a variety of catalysts including equity market volatility, intervention by Japanese authorities in the yen, a hawkish shift by the BoJ, and political uncertainty in the U.S. We look mainly to capitalize on idiosyncratic mispricings where there are clear fundamental and value differences.
Developed Market Rate/Foreign Currency
Monthly Review
Developed market interest rates fell in July as economic data continued to weaken and central banks suggested that they would soon see it appropriate to ease policy. In the U.S., consumer price inflation continued to decelerate, with year-on-year core inflation coming in below expectations once again. Various activity data – including the Institute for Supply Management (ISM) surveys – also pointed to a cooling in economic activity and, in particular, the labour market. In the Eurozone, while inflation prints were roughly in line with expectations, PMIs pointed to a continued worsening in economic conditions. Expectations of more aggressive near-term easing also led yield curves to steepen – a dynamic that was accentuated as markets considered the outlook for future fiscal policy, particularly in the U.S.
On foreign exchange, the U.S. dollar ended the month lower against G10 peers, as rate differentials narrowed between the U.S. and the rest of the world. The Japanese yen gained 7% against the dollar as several catalysts – including the Bank of Japan’s policy normalization, equity market volatility and political uncertainty – led to an unwinding of carry trades which also benefited the Swiss Franc. The Antipodean and Scandinavian currencies underperformed.
Outlook
We are short duration in portfolios, mainly through an underweight in Japan, where the central bank turned more hawkish in July and surprised economists with a second rate hike. The Bank of Japan will also likely reduce bond purchases in the coming quarters and has primed markets to expect more hikes if its economic projections materialize, giving it more confidence in sustainable domestic inflation. Outside of Japan, we are long duration in Australia, New Zealand and Canada versus the U.S., as well as in such emerging markets as South Korea.
Emerging Market Rate/Foreign Currency
Monthly Review
Performance was positive for the major segments of Emerging Markets Debt (EMD). The Fed held rates at the July Fed meeting, which was expected, but expectations for a cut at the September meeting are split. The U.S. dollar weakened in reaction to disappointing jobs data, which was a macro boost for EM currencies. Spreads widened for both sovereign and corporate credit spreads, but performance was supported by the fall in U.S. Treasury rates. The year of global elections continued with Venezuela’s Presidential election at the end of the month. President Maduro claimed to be the winner, but there is concern surrounding the legitimacy of the results, and protests erupted across the country. The Ethiopian Central Bank allowed the birr to float after three decades of managing its currency, the IMF backed the devaluation and funding was released from the World Bank and the IMF. Despite strong performance for the month, flows turned to outflows for both hard currency and local currency funds.
Outlook
We continue to find valuable opportunities in the asset class as valuations remain attractive and assets are relatively cheap. Credit spreads are near long term averages but have marginally widened since the end of the first quarter. The value in the hard currency space is found outside of the benchmark as spreads are wider and several countries continue with reforms and restructurings. EM currencies strengthened during the period, and we continue to find pockets of opportunity in the local segment of the market. Local rates remain attractive as many EM central banks continue to cut rates as inflation steadily decreases. Countries matter most when investing in emerging markets and our team of country pickers continues to find opportunities across the full investment universe.
Corporate Credit
Monthly Review
July saw risk assets stabilize following a volatile start to the summer as tail-risk political headlines abated and economic data continued to point to a soft-landing narrative. European investment grade (IG) spreads tightened, outperforming U.S. IG and swap spreads, while government bonds rallied. Sentiment was dominated by several factors: Firstly, French elections resulted in a hung parliament which was well received by investors as tail-risk scenarios of large fiscal programmes faded and risk premia was priced out. While in the U.S., President Biden stepped down and endorsed Vice President Kamala Harris. Secondly, the latest U.S. CPI print confirmed the slowing trend in inflation and data in releases (both inflation and growth) in June continue to support the “soft landing” narrative. The data was in line with central bank actions, the Bank of England joined the ECB, the SNB and the Riksbank in starting their policy rates easing cycle. Thirdly, the earnings calendar kicked off with a positive set of results from financials while corporate earnings were more mixed (weaker pricing with flat volumes). Finally, primary issuance came in higher than expected and with tail-risk political scenarios off the table, investor demand for risk was strong with large new issue order books and limited new issue premiums.
In July, performance in the high yield market was generally strong. The primary driver of performance was sharply lower U.S. Treasury yields, with the yield on the 5-year decreasing approximately 50bps during the month. Modest spread widening offset a portion of this contraction; however, the average yield in the high yield market ultimately tightened by more than 30bps on the month. The lowest quality segment of the high yield market generally outperformed in July as several large, distressed capital structures experienced transitory technical strength amid supportive idiosyncratic headlines, while commentary from management teams, manufacturing PMI, an increase in jobless claims and indicators on low-end consumer health foretold potentially challenging economic conditions ahead.
Global convertible bonds had a strong July, but underperformed both global bonds and equities. The first half of the month saw risk assets rally on the back of weak economic data and a positive inflation print that caused investors to dial up expectations of a September rate cut from the Federal Reserve. Equities of small cap companies generally outperformed amid the expectation of an imminent rate cute, boosting returns for the convertible bond asset class. However, the momentum of large cap companies weakened mid-month as earnings reports from several large companies missed expectations. The result was a bifurcation between the large technology companies, which have driven year-to-date returns, and small cap companies. The global convertible bond primary market continued its impressive pace as $8.6 billion of new deals priced during July. This brought total year-to-date issuance to $69 billion, a 60% increase over the comparable period in 2023.
Outlook
Looking forward our base case remains constructive for credit supported by expectations of a “soft landing”, fiscal policy that remains supportive of growth/employment/consumption and strong corporate fundamentals. Lighter gross issuance in 2H24 coupled with strong demand for the “all-in” yield offered by IG credit is expected to create a supportive technical dynamic. When looking at credit spreads, we view the market close to fairly priced and therefore see carry as the main driver of return, with the potential for a reversal in some of the widening seen in June if we see a positive election outcome in France. Given the uncertain medium term fundamental backdrop we have less confidence in material spread tightening.
Our outlook for the high yield market remains somewhat cautious as we progress through the third quarter. The high yield market is contending with increasing uncertainty and several likely sources of volatility over the intermediate term, with the ultimate question centering on the magnitude of the anticipated volatility. The key issues are central banks’ evolving monetary policy, economic conditions, the labor market and consumer health, and ultimately, the health of the corporate fundamentals of high yield issuers. High yield faces this uncertainty with historically attractive all-in yields and an average spread that, when excluding the distressed segment of the market, is approaching all-time lows. Further inspection of valuations reveals a market that has become increasingly bifurcated by both sector and credit quality.
We continue to remain constructive on the global convertible bond market as we progress through the third quarter of 2024. We believe global convertible bonds currently offer their traditional balanced profile of upside equity participation and downside risk mitigation. New issuance in the first half of the year was strong and we expect issuance to continue to increase in the second half of the year as corporations continue to look to refinance existing convertible bonds as well as traditional debt in the convertible bond market given the relatively high interest rate environment. A more traditional asymmetric return profile coupled with an expectation of an increase in new supply continues to give us optimism for global convertible bonds as we progress through the year.
Securitized Products
Monthly Review
U.S. agency MBS spreads tightened 7 in July to 142bps above comparable duration U.S. Treasuries. Agency MBS spreads are now 4 bps wider in 2024. Current coupon agency MBS spreads are slightly wider in 2024, while nearly all credit spreads have tightened materially. Lower coupon U.S. agency MBS passthroughs outperformed higher coupon MBS in July as interest rates fell, and lower coupons have longer rate and spread durations. The Fed’s MBS holdings shrank by $38 billion in July to $2.324 trillion and are now down $405 billion from their peak in 2022. U.S. banks’ MBS holdings rose by $15 billion to $2.59 trillion in July, resuming the trend of bank increases after a small decrease in March; however bank MBS holdings are still down roughly $396 billion since early 2022. Securitized credit spreads were slightly wider to unchanged in July as new issuance remained strong but demand did manage to keep up. Relative to other fixed income sectors, securitized credit sectors underperformed longer duration fixed income sectors given the sharp drop in rates, but securitized credit did perform in line with U.S. and Euro HY given the strong cash flow carry.
Outlook
After several months of spread tightening across securitized products through May, we saw spreads largely stabilize in July and we expect spreads to stabilize at current levels in August as securitized credit spreads are approaching agency MBS spread levels given the differentiated performance over the past several months. Overall demand levels remain strong, but we believe it will be challenging to push spreads much tighter from current levels. Securitized credit sectors have been among the best performing sectors in 2024, and we have seen performance to begin to normalize and believe that this will continue in the coming months. We also believe that rates will likely remain rangebound for much of 2024, and that returns will result primarily from cashflow carry in the coming months. We still believe that current rate levels remain stressful for many borrowers and will continue to erode household balance sheets, causing stress for some consumer ABS, particularly involving lower income borrowers. Commercial real estate also remains challenged by current financing rates, and some sectors may see declines in operating revenue in 2024. Residential mortgage credit opportunities remain our favorite sector currently and is the one sector where we remain comfortable going down the credit spectrum, as we remain more cautious regarding lower rated ABS and CMBS. We have moved from a neutral to a positive view on agency MBS valuations, which are one of the very few sectors that have cheapened up thus far YTD. They continue to remain attractive versus investment-grade corporate spreads and versus historical agency MBS spreads, but we believe that agency MBS spreads have stabilized.
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