Insights
Lost in the Forest
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Global Fixed Income Bulletin
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June 14, 2024
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Lost in the Forest
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June 14, 2024
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Lost in the Forest
Lost in the Forest |
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May saw global government bonds rallying for the first three weeks, followed by a slight sell off to close out an otherwise uneventful month. Japan was one of the few exceptions, as bond yields continued to rise as the need for eventual rate hikes, later in the year, became more certain. Emerging market bond yields followed pace with their developed market counterparts over the month, but lingering inflation made it difficult to outperform. The U.S. Dollar had its first down month of 2024 with the euro, pound, and other developed/emerging market currencies outpacing the clear leader of the first four months of the year. Within spread sectors, investment grade (IG) credit spreads were broadly tighter with Euro IG marginally outperforming the U.S. Within high yield, U.S. high yield spreads were wider over the month, while Euro high yield spreads tightened significantly. Securitized credit spreads continued to tighten and have been one of the best performing sectors year-to-date within the fixed income universe.
Fixed Income Outlook
May proved to be a good month for U.S. dollar bonds, but not as much for the rest of the world. U.S. Treasuries were buoyed by weaker-than-expected data supporting the idea that the first quarter’s outsized inflation prints, and strong aggregate demand data, were not the start of a new trend, e.g., the “no landing” / “no rate cut” scenario. In many ways this was not surprising as U.S. growth peaked in Q3 last year and has been decelerating since. The big question on investors’ and policy makers’ minds is how far will the deceleration in growth and employment go? The worries over the “no landing” scenario were replaced by optimism that economies were back on track for the “soft-landing” version -- a world of rate cuts and falling inflation accompanied by trend-like growth.
This scenario looks more probable than two months ago with central banks in Sweden, Switzerland and now Canada and the European Central Bank, cutting rates. Central banks are eager to cut rates and are looking for excuses to do so, and that excuse is lower inflation and expectations of even lower inflation in the future. The Fed is turning out to be the most recalcitrant to initiate a rate cut and justifiably so. Recently, the U.S. has had the strongest economy in the world and even with the deceleration underway, they are handily outperforming most other countries including many emerging markets.
Despite still high levels of growth and inflation (relative to targets), bond investors have become optimistic about future Fed policy and are now forecasting up to two Fed rate cuts in 2024, when, as of earlier this year, there was less than one expected. This is not unreasonable if inflation falls further, and if labor markets continue to ease. Hard U.S. economic data still does not suggest that a rate cut is imminent, nor does sticky service sector inflation. Service sector data still does not point to material economic weakness and with no credit imbalances in the U.S. economy, it is difficult to see the need for imminent rate cuts. At some point rate cuts will happen, just not yet.
The absence of U.S. rate cuts, lack of clarity about the extent of easing cycles (both in the U.S. and elsewhere), and the continued inversion of yield curves makes long-maturity bonds on the margin less attractive. 10-year U.S. Treasuries are flirting with the 4.25% level, which we believe is likely to be the limit unless data materially weakens, particularly employment data. Moreover, real yields on 10-year U.S. TIPs look like they will run into resistance around the 1.9-2.0% level. While it is difficult to see what will drive yields back to their 2024 highs (c. 4.7% in 10-year U.S. Treasuries), it is too early to jump onto the bullish bandwagon, and a similar situation exists around the world where yields have been following the U.S. lower.
Credit markets have essentially shrugged off the May equity volatility and remain well supported. While there is no doubt that most credit spreads are rich by historical standards, we do not believe they are expensive to fundamentals. While we do not expect further meaningful tightening, there is no reason to believe that spreads will widen given still sound fundamentals and macroeconomic performance, which should be supportive of spreads. Strong yield-oriented buying should prevent spreads from widening, and a neutral to modestly overweight credit position still seems warranted. 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 fall, and spreads could widen. However, this remains a risk and not a foregone conclusion as the U.S. economy continues to perform well and the global economy remains on an upswing. We remain overweight credit in portfolios, paying more attention to idiosyncratic risks rather than general macro spread widening risks.
Emerging market (EM) local market returns were mixed in May, testifying to the cross-current of forces at work. While EM central banks had been in the vanguard of cutting rates, that is no longer the case. Most rate-cutting EM central banks have paused or are slowing down the pace of cuts. It is no longer clear if inflation will fall faster in EM countries than in developed countries and if EM central banks will be able to aggressively cut rates. That said, DM central banks have been more slow to begin easing policy, which has led to a more benign global backdrop for EM countries. This could restart the carry trade where investors buy higher yielding currencies and sell lower yielding ones. We have sympathy for this view but remain concerned about idiosyncratic risks such as the political upsets in recent elections in Mexico, India, and South Africa. We have reduced exposure to Latin American rates in favor of U.S. and Euro credit.
Given the uncertainty surrounding the robustness of the global economy, the extent of DM central bank easing and the timing of the first U.S. rate cut, we continue to find the best fixed income opportunities in shorter maturity 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 very 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. On one hand, other central banks front running the Fed should be dollar supportive, but that has not been the case. With the global economy’s trajectory looking better than the U.S. (albeit from a low base), the period of strong U.S. economic outperformance may be coming to an end. It is too early to be sure, but the groundwork is being laid. The global FX carry trade is likely to resurrect itself as idiosyncratic risks die down. As such, we are not convinced that large pro or anti U.S. dollar trades make sense. The best opportunities remain in non-USD currencies such as small Latin EM currencies, and on the negative side, the Canadian dollar which should struggle with weak economic growth and easing monetary policy.
Developed Market Rate/Foreign Currency
Monthly Review:
May was a month of two halves in the DM rates markets. Bond markets rallied in the first half of the month as the Fed leaned dovish at its May meeting, continuing to signal an intention to cut interest rates. Economic data, such as U.S. retail sales, also came in weaker than expected while the April U.S. CPI print ended a string of upside inflation surprises, with services inflation in particular moderating. Later in the month, however, policymakers turned less dovish, and data came in stronger. Various Fed speakers also began to explicitly reference further policy tightening, though they were quick to stress hikes were not in their base case, while minutes from the May meeting revealed that a few policymakers doubted just how restrictive current policy is. Inflation in other markets – most notably Australia, the UK, and the Eurozone – were also higher than expected and showed signs of price pressures reaccelerating. On foreign exchange, the U.S. dollar ended the month weaker against all G10 peers. Sterling gained 2% against the USD as higher inflation reduced Bank of England rate cutting expectations, while the Australian dollar also gained 2.7% on a hawkish inflation print. The Scandinavian currencies were the biggest outperformers given the risk-on environment. Given the divergent cross-market monetary policy outlooks, we continue to favor the Australian dollar over the Canadian dollar.1
Outlook:
While several DM central banks are widely expected to cut rates in the coming months, the depth of the cutting cycle is more important for fixed income markets than the timing of the first cut. Recent data and policy communication suggests central banks will likely adopt a cautious approach. We stay short duration as momentum is bearish, carry is negative and valuations in longer-maturities are unattractive. Cross-market, we prefer to be short Australian vs. U.S. rates due to evidence of still-sticky inflation and the RBA turning more hawkish. We also remain underweight duration in Japan, where communication has turned less dovish amid concern about the weak yen, and confidence has grown that positive wage-price dynamics will lead to sustainably higher inflation.
Emerging Market Rate/Foreign Currency
Monthly Review:
May performance was positive for the major segments of emerging markets debt (EMD). Global bond markets reacted positively to softer than expected U.S. inflation for April, and this helped support EMD assets as well. Most EM currencies strengthened month-over-month and the U.S. dollar weakened. The Chilean peso rallied as copper, a major export for the country, continued the price rally that started in April. One notable outlier was the Philippine peso, which continued its year-to-date weakening streak as inflation remains sticky. As inflation continued to accelerate, neighboring Indonesia hiked rates in April to support the currency, but a rate hike for the Philippines is not likely due to the potential negative impact on economic growth. Spreads marginally tightened for the EM corporates index, but both the sovereign and corporate index were supported by U.S. Treasury yields. After a brief flows reversal in April for hard currency bonds, both local currency and hard currency bonds reverted to outflows in May.2
Outlook:
Valuations for emerging markets debt are still attractive and assets are cheap, which presents an attractive entry point for investors. Spreads for hard currency assets are near long-term averages, but bifurcation in the markets and off-benchmark countries provide opportunities for investors. The direction of monetary policy in the U.S. is likely easing, which will provide a supportive backdrop for emerging markets assets. However, growth expectations along with credible monetary policy will continue to support local assets. Real yields are near historic high levels and with continued falling inflation this provides a good environment for bond investors. Reform stories and positive turns in policy continue to make progress which is exciting for a team of country pickers.
Corporate Credit
Monthly Review:
In May, investment grade credit spreads continued to grind tighter, with Euro outperforming the U.S., and credit volatility remained low. Market sentiment was dominated by several factors: Firstly, inflation and growth data surprised to the upside in Europe but in-line in the U.S. Secondly, central bank policy continues to diverge as the ECB is expected to cut rates in June while the Fed remains hawkish. Thirdly, Q1 corporate reporting was positive for credit, with the confirmation that corporates were seeing limited stress in their business with the majority running low risk strategies. M&A activity continues to be conservatively funded from a bondholder perspective. Finally, the technical remains strong as the higher-than-expected supply is met with strong demand.3
May was a modestly strong month for the U.S. and global high yield markets. The average yield in the U.S. high yield market fell by more than 35 basis points (bps) over the first two weeks of the month before gradually climbing in the second half as spreads modestly widened. Ultimately, the average spread ended the month only slightly higher while the average yield was modestly lower on the back of lower U.S. Treasury yields. The technical conditions in high yield strengthened in May as retail demand was notably stronger, gross issuance increased and net issuance remained light, with capital markets squarely focused on refinancing. Finally, traditional default activity among high yield bond issuers was non-existent in May; however, the volume of distressed exchanges remained elevated.4
The global convertible bond market had a modestly strong month as the balance of macroeconomic data was generally interpreted as supportive of risk assets. While the asset class generated positive returns, it underperformed both global equities and global bonds in May. New issuance was historically strong with $18 billion pricing during the month. The U.S. led the way in terms of primary issuance followed closely by Asia, which saw two large deals from Alibaba and JD.com, at $5 billion and $2 billion, respectively. Both deals were among the largest deals ever for the region.5
Outlook:
Looking forward, our base case remains constructive for credit given expectations of a “no/soft landing”, strong corporate fundamentals supported by low-risk corporate strategies, accommodative fiscal policy and robust demand for the “all-in” yield creating a supportive technical dynamic. When looking at credit spreads, we view the market as fairly priced and therefore view carry as an attractive return opportunity but given the uncertain medium term fundamental backdrop, we have less confidence in further spread tightening.
Our outlook for the high yield market is somewhat cautious as we progress through the second quarter. The high yield market is contending with several elements of uncertainty, and potential sources of volatility, including the forward path of monetary policy, U.S. fiscal and regulatory policy, the labor market and consumer health and, ultimately, economic growth and the health of the corporate fundamentals of high yield issuers. High yield faces this uncertainty with the unique combination of historically attractive yields and an average spread that ranks near cycle lows. Further inspection of valuations reveals a market with ample dispersion, significant bifurcation, and continued opportunity at the security level.
We continue to remain constructive on the global convertible bond market as we progress through the second quarter of 2024. We believe global convertible bonds currently offer their traditional balanced profile of upside equity participation and downside bond protection. New issuance in the first quarter was strong and we expect issuance to continue to increase in 2024 as corporations 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 in 2024.
Securitized Products
Monthly Review:
U.S. agency MBS spreads tightened 10 bps in May to 143 bps above comparable duration U.S. Treasuries. Agency MBS spreads are now 4 bps wider in 2024. Current coupon agency MBS spreads are slightly wider year to date, while nearly all credit spreads have tightened materially. Lower coupon MBS outperformed higher coupon MBS as interest rates fell, and lower coupon passthrough agency MBS have longer rate and spread durations. The Fed’s MBS holdings shrank by $30 billion in May to $2.35 trillion and are now down $385 billion from their peak in 2022. U.S. banks’ MBS holdings rose by $1.62 billion to $2.54 trillion in May, resuming the trend of bank increases after a small decrease in March; however, bank MBS holdings are still down roughly $455 billion since early 2022. Securitized credit spreads continued to tighten in May as demand remained very strong, and new issue deals were consistently oversubscribed. Securitized new issuance remained high in May, but the increased supply continues to be easily absorbed. Relative to other fixed income sectors, securitized credit sectors outperformed the Global & U.S. aggregate, Euro investment grade corporates, and U.S. & Euro High Yield.6
Outlook:
After several months of spread tightening across securitized products, we expect spreads to stabilize at current levels in June as securitized credit spreads are approaching agency MBS spread levels. 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, but performance should normalize 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 currently remain our favorite sector 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 year to date, and they continue to remain attractive versus investment-grade corporate spreads and versus historical agency MBS spreads.