Analyses
Riding the Rollercoaster
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Global Fixed Income Bulletin
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novembre 21, 2024
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Riding the Rollercoaster
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novembre 21, 2024
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Riding the Rollercoaster
Riding the Rollercoaster |
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In October, the fixed income market experienced significant fluctuations following a 50-basis point (bp) interest rate cut by the Federal Reserve (Fed) in September. The initial optimism surrounding the Fed’s decision soon gave way to reconsideration, as robust economic data prompted a sell-off in rates. The prevailing sentiment was that the pace of interest rate cuts might not be sustainable, especially as recession risks appeared to diminish. This shift in perception coincided with the upcoming U.S. election and the increased speculation about a potential Trump victory, which contributed to a notable rise in U.S. Treasury yields. Specifically, the yield on the 10-year note surged by 50 bps during the month.1
This trend was not limited to the U.S.; government bond yields saw upward momentum globally. In Germany, the 10-year rate rose by 27 bps, while the U.K. experienced a 44 bps increase.2 Other notable movements included a 53 bps rise in Australia, a 52 bps increase in South Africa, and a 73 bps uptick in Mexico.3 The increase in yields was a boon for the U.S. dollar, which appreciated 3.2% against a basket of currencies.4 Despite rising government bond yields, credit spreads continued to tighten, with high yield bonds outperforming investment grade bonds, and the euro area markets outperforming their U.S. counterparts.
Initial Market Reaction Following a Trump Victory and Potential Red Sweep
In the wake of a Trump victory and a potential red sweep in the elections, the financial markets displayed immediate reactions. The yield on the 10-year U.S. Treasury bond climbed to approximately 4.43%, representing a 14-basis point increase from the end of October. The U.S. yield curve exhibited a bear steepening effect, with the 2s/10s spread (the spread difference between 10- and 2-year Treasurys, steepening by 7bpsand the 5s/30s spread steepening by 4 bps. This phenomenon was mirrored in developed markets, with yields rising by 10 bps in Germany, 6 bps in Japan, 9 bps in both the UK and Canada, and 13 to 14 bps in Australia and New Zealand. Conversely, emerging markets generally experienced declines in yields.
The U.S. dollar witnessed a rally, particularly against the euro, following Trump's reelection. Equities also displayed strong performance; domestic small-cap stocks and cyclical sectors outperformed, while European, Chinese, and emerging market equities lagged. In the credit markets, both investment-grade and high-yield spreads tightened, reaching their narrowest levels since 2005. Overall, the market’s initial reaction suggests a bullish outlook, driven by expectations of fiscal stimulus and deregulation under a Trump administration, indicating a shift in investor sentiment towards riskier assets.
Fixed Income Outlook
After showing consistent strength through the summer, bond market performance turned distinctly negative in October. The 10-year U.S. Treasury yield rose approximately 50 bps, generating the worst monthly bond market performance since the third quarter of 2022. This pushed year-to-date returns below that of cash and most other sectors outside of high yield and loans. This was especially unusual considering it occurred on the back of the Fed’s 50-bps rate cut. This rollercoaster-like performance is likely to continue as the doors open to even more macroeconomic, policy and rate volatility due to the surprisingly strong Republican victory in the recent U.S. election.
After the summer's run of weaker-than-expected U.S. labour market reports pushed the Fed toward cutting rates by 50 bps, labour market data for August and September rebounded with the unemployment rate falling from 4.3% to 4.1%.5 Moreover, data on the real economy continued to power ahead. Gross domestic product (GDP) grew at an annualised rate of nearly 3% in the third quarter,6 and fourth quarter growth is forecast to be in the neighbourhood of 2.5%. Although there is no doubt that hiring has slowed, it has not collapsed, and the weakness can be explained by the usual ebbs and flows in hiring patterns along with concerns over the results of the presidential election. Rather than demand weakness alone, increased labour supply has driven unemployment higher over the past year. Going forward, we expect to see more stability and less deterioration in employment, suggesting the Fed would not need to aggressively cut interest rates over the next 12 months. As of early November, we believe one more rate cut is reasonable for 2024, taking the ceiling on the Fed Funds Rate to 4.5%.
That said, there is now a heavy focus on the implications of the November U.S. elections. The market’s immediate reaction on Wednesday, 6 November was clear. The results were: great for stocks; especially great for financial stocks; good for credit; terrible for U.S. Treasury bonds; not so good for the rest of the world’s bonds; good for the U.S. dollar. This movement in asset prices seems logical given Trump and the Republicans’ platform and policy preferences. Questions surrounding how markets will shift under policy and economic changes linger. One question is: how much dismantling of the Inflation Reduction Act and CHIPS and Science Act will occur? These policies have been strongly positive for the U.S. economy, and if the Republicans end these programs without replacement, fiscal policy may be less expansionary than expected, putting less pressure on inflation and the Fed.
There is no doubt that the Republicans’ sweeping victory in the November election has further changed the calculus of where bond markets are headed. Even before the election it was becoming less clear how much easing the Fed would do given the surprising strength in the U.S. economy. This is particularly true as recent Fed rate cuts were more in line with a recalibration of the rate structure than a move to counter concerns about imminent economic weakness. The need for this proactive stance, already being questioned prior to the election, is even more open to debate post-election.
The election has given the forthcoming Trump administration, along with a likely Republican-controlled Congress (as House leadership was still undecided but leaning Republican at the time of writing), considerable leeway to adopt large swathes of the Trump agenda as stated in policy proposals and campaign rhetoric. How much of this is actually implementable is an open question. It will be months before some clarity emerges, depending on staffing, prioritization of policies, etc. In the interim, the market will rely on the agenda as we currently understand it: tax cuts (both new and continuation of the 2017 cuts), tariffs (and potential trade wars), deregulation, and immigration (reduction thereof as well as possible heightened deportations). Markets will be awaiting more details on the new administration’s legislative and executive order priorities and the timing and implementation of these policies to gain more confidence about the trajectory of inflation and growth.
The market’s initial reaction to price out another rate cut in 2025 was reasonable, in our view, but how much more needs to be priced out remains to be seen. The implications for the rest of the world’s central banks are more ambiguous. The initial reaction on 6 November was bullish: the Trump agenda was expected to be good for U.S. growth/inflation but bad for growth elsewhere, meaning central banks outside the U.S. would step up their easing in response, which led to a distinct steepening of yield curves. Although we are sympathetic to this reaction, we are not sure it is entirely correct. A stronger U.S. dollar, higher tariffs and less efficient allocation of resources are inherently inflationary. The growth impact is probably negative. The questions are: which comes first and which is viewed as worse from a monetary policy perspective? This will likely complicate the rate-cutting paths of central banks around the world. We have already seen the Norwegian and Indonesian central banks postpone cutting interest rates due to currency weakness (albeit not directly related to Republican electoral success).
In terms of impacts on bond yields, we can expect the following: further upward pressure on yields, steeper yield curves due to inflationary pressures and rising risk premiums. We believe the new floor on the 10-year U.S. Treasury yield is likely to be 4%, with a ceiling of 5%, the 2023 high.
Credit markets were performing well before the election, and they have performed even better in the days following. This initial response makes sense as a stronger U.S. economy leads to improved cash flows and deregulation and protectionism help U.S. profits (at least in aggregate). However, the longer-term impact is less obvious. Greater opportunities and more regulatory leeway usually lead to riskier behaviour and greater leverage — not usually positive for creditors. With credit spreads on the tight side (expensive by historical standards but not overvalued), opportunities remain attractive, but we do not expect especially high returns.
Our credit market strategy is focused on avoiding problematic companies and building as much yield into the portfolio without taking undue risks. There is little reason to believe spreads will materially widen when economic growth is decent and central banks are predisposed to cutting interest rates. Yield-oriented buying should contain spread widening. We remain modestly overweight credit in our portfolios with a modest bias to higher quality.
Emerging market (EM) bonds are unlikely to thrive under a Trump-led Republican government. Stronger growth but higher rates and weaker global trade linkages are not usually conducive to strong EM performance. That said, we believe countries with solid economic outlooks, decent growth, falling inflation and a central bank able and willing to cut interest rates despite policy changes in the U.S. are likely to perform well. Country and security selection remain imperative. We continue to avoid Mexican and Brazilian bonds as their respective markets deal with political uncertainty (Mexico), fiscal risks (Brazil) and Trump policies.
With all the noise and uncertainty now coming out of Washington, we believe the most attractive opportunities remain in securitized credit, particularly in U.S. mortgage-backed securities. U.S. households with prime credit ratings have strong balance sheets, which should continue to be supportive of consumer credit and ancillary structures, especially as housing prices remain firm. Changes in U.S. tax policy should also be supportive. Higher coupon U.S. agency mortgage securities remain relatively attractive versus investment grade corporates, and we believe they are likely to outperform U.S. Treasury bonds. As in our corporate credit positioning, we are looking to move our securitized credit exposures up in credit quality and out of non-U.S. structures given tighter spreads and increased macroeconomic risks in Europe. One area in securitized credit that is vulnerable to a potentially changing Fed policy is commercial mortgage-backed securities (CMBS). If interest rates do not fall as much as expected, the refinancing of many U.S. office-backed deals will become problematic. We continue to generally steer clear of this sector.
In currency markets, the outlook for the U.S. dollar has improved since Trump’s election. Easier fiscal policy, tighter monetary policy (relative to previous expectations), trade wars and stronger U.S. growth all bode well. However, one caveat to this upbeat narrative is surprisingly weak U.S. employment. Further deterioration will give the Fed room to continue to cut interest rates as long as the Trump agenda does not upset the inflation story. The U.S. economy remains exceptional with regard to its growth trajectory, productivity performance, profit performance and level of yields. It is a high hurdle for other currencies to beat these fundamentals.
Developed Market Rate/Foreign Currency
Monthly Review:
Developed market bond yields rose in October as economic data came in better than expected. The September jobs report, released in early October, showed that the U.S. economy added 254,000 jobs during the month, with broad-based gains across sectors, and the unemployment rate fell to 4.1%. Concerns about material weakness in the labour market thus began to ease. Likewise, the September inflation report was stronger than expected, though investors were encouraged by the moderation in the shelter-related components – in particular owners’ equivalent rents.
As the U.S. presidential election drew nearer, markets also began to weigh the potential outcomes and their implications for the global economy and asset prices. The U.S. dollar surged as markets considered the outlook for global trade, while volatility increased in currencies such as the Chinese renminbi. Longer-maturity yields also rose as investors reassessed the fiscal outlook and its impact on bond markets. Meanwhile, outside the U.S., inflation data surprised to the upside in Europe, while activity data and PMIs pointed to a more resilient economic backdrop.
On foreign exchange, the dollar appreciated against major currencies, reversing its previous weakness, as rate differentials widened between the U.S. and the rest of the world. The rate-sensitive Japanese yen weakened 6% against the dollar despite promising newsflow on the coming round of wage negotiations, while the New Zealand dollar also underperformed as the Reserve Bank of New Zealand delivered a 50 bp rate cut and turned dovish given the weak local economic outlook. The euro was the most resilient G10 currency. We remain positive on the Australian dollar against the Canadian dollar given favourable economic fundamentals.
Outlook:
We are neutral on duration in DM ex-Japan and retain our long-standing steepening exposures, particularly in the U.S. Cross-market, we are underweight U.S. duration. UST valuations and expectations for the Fed still seem demanding in comparison to other markets and central banks. In particular, we are underweight USTs vs New Zealand government bonds and gilts, although we have turned neutral on Canada vs the U.S. We also remain underweight Japanese Government Bonds, and long Japanese breakevens, given we think Japanese inflation is moving structurally higher and will result in the Bank of Japan raising interest rates higher than the market currently prices.
Emerging Market Rate/Foreign Currency
Monthly Review:
Performance was negative for EMD markets for the month of October. Uncertainty surrounding the U.S. election caused U.S. yields to rise giving back the rally from Q3 and the U.S. dollar strengthened. EM currencies broadly suffered and sovereign and corporate credit spreads compressed. Latin American currencies in particular suffered with the Chilean peso, Colombian peso, and Brazilian real notably selling off due to falling commodity prices and concerns about a shift in Fed policy. The Uruguayan peso rallied following positive results from the general election where a controversial pension overhaul reform failed to pass. The Fall IMF Meetings were held in Washington, D.C. where discussions of the U.S. election were apparent in many meetings and global growth is expected to be stable and modest. The “sugar high” from China’s coordinated policy measures from September subsided during the month as the Chinese yuan sold off and the MSCI China Equity index sold off almost 6%. Asset class flows turned negative for hard currency funds while local currency funds were flat – YTD the asset class remains in outflows although not nearly as severe as the two previous years.7
Outlook:
Uncertainty surrounding the U.S. election is causing some degree of volatility in the macro environment – but opportunity is prevalent in areas of emerging markets debt. The Fed is expected to continue to cut rates this year which will be supportive for EM central banks, selective overweights to EM local rates will be a good place to be when those EM central banks cut rates. Broadly, we look beyond the benchmark for countries making structural changes and positive reforms. By diversifying away from high beta EM countries that are more likely to be subject to market swings we can focus on country fundamentals and good policy which should drive EM asset performance. This is very differentiated across emerging markets, so country level analysis is critical for uncovering value.
Corporate Credit
Monthly Review:
A substantial narrowing of European swap spreads led to European investment grade credit spreads tightening, relative to government yields but closing a touch wider versus swaps, as Euro IG outperformed U.S. IG this month. Developed market government bond yields rose as robust economic data and inflation prints led the market to pare back the speed and size of rate cut expectations. Sentiment was dominated by: Firstly, on the data front in Europe, Q3 GDP growth surprised to the upside, while Spain continued to outperform, and German consumers unexpectedly helped the country to avoid a recession. Euro area headline Harmonised Index of Consumer Prices (HICP) inflation bounced back from 1.7% in September to 2.0% in October, with core inflation printing above expectations at 2.7% year over year. As expected, the ECB delivered a 25bps cut. Both the statement and the press conference pointed to a mildly dovish shift on the Governing Council. In the UK, the new labour government delivered their Autumn budget. The policies were broadly in line with market expectations, however UK Gilts sold off and underperformed other developed markets on additional supply and inflationary concerns. While U.S. data points to a resilient consumer and strong labour market, even as JOLTS disappointed. Corporate earnings came in mixed, but most full year guidance has been reiterated and we have not seen major changes to capital allocations. There were some exceptions, such as autos and luxury goods, where earnings have been weak. Finally, primary issuance in October came in at the high end of expectations at EUR 40bn and was well absorbed. Despite the higher than expected supply, investor demand for risk was strong with large new issue order books and limited new issue concessions.
Performance in the U.S. and global high yield markets cooled in October amid a sharp month-over-month increase in U.S. Treasury yields. The average spread in high yield reached post-Global Financial Crisis lows in late October, partially absorbing the move higher in Treasury yields. Against this backdrop, the lower-quality shorter-duration segments of the high yield generally outperformed in October. The technical conditions in high yield remained strong in October, supported by a decrease in primary issuance and additional inflows into the asset class. Finally, the trailing 12-month par-weighted default rate including distressed exchanges continued to fall during the month.8
Global convertible bonds eked out a modest gain in October, but performance was largely driven by a single issuer in the information technology sector. The issuer is a U.S.-based software development company that is the largest corporate holder of bitcoin in the world as well as the second largest constituent in the FTSE Global Focus Convertible (USD Hedged) Index. The position in the Index was up ~35% during the month as the cryptocurrency performed well in October. The strong performance of this single issuer helped the asset class to outperform both global equities and global bonds during October. New issuance was strong again in October, but was largely driven by a large U.S.-based company that issued a $5 billion mandatory preferred. In total, $11.1 billion priced during the month, which brought year-to-date issuance $94.2 billion. This represents a 45% increase over the same time 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 fourth quarter 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 as offering some value but see carry as the main driver of return. Given the uncertain medium term fundamental backdrop we have less confidence in material spread tightening.
Our outlook for the high yield market has improved. While the probability of a soft landing has increased, it appears the preponderance of market participants also share this belief, and this scenario appears to be almost fully priced in at October-end. The catalysts with the potential to undermine this scenario are consistently present and we remain focused on these in a continued effort to position our strategy to outperform, should market conditions deteriorate. These catalysts include the lagged effects of restrictive policy, economic conditions, consumer health and the fundamental health of high yield issuers. The high yield market ended October with an average spread near post-GFC lows, which was reached mid-month, and a historically attractive average yield that ended October 34 bps higher.9
We continue to remain constructive on the global convertible bond market as we progress through the fourth quarter. We believe global convertible bonds currently offer their traditional balanced profile of upside equity participation and downside bond protection. New issuance has been strong and we expect issuance to remain strong despite interest rate cuts from global central banks and potential volatility from the U.S. election and rising geopolitical tensions. A more traditional asymmetric return profile coupled with an expectation of additional new issuance continues to give us optimism for global convertible bonds as we progress through the year.
Securitized Products
Monthly Review:
U.S. agency mortgage backed securities (MBS) spreads widened 24 bps in October to a spread of 154 bps above Treasuries. Agency MBS spreads are 15 bps wider year to date in 2024. Given the material tightening in other credit sectors, agency MBS remain one of the only sectors in fixed income with attractive valuations. The Fed’s MBS holdings shrank by $16 billion in October to $2.258 trillion and are now down $438 billion from its peak in 2022. U.S. banks’ MBS holdings rose by $23 billion to $2.66 trillion in October resuming their upward trend; however bank MBS holdings are still down roughly $328 billion since early 2022.10 Securitized credit spreads were mixed but essentially little changed in October. Securitized issuance remained strong in October and the supply continues to be well absorbed and met with strong demand. Relative to other fixed income sectors, securitized credit sectors outperformed. This outperformance was due to a combination of having a relatively short interest rate duration —thus less exposure to the sell-off in rates—and the high cashflow carry of these securities helped offset the negative impact that the move in rates did have. YTD securitized credit has outperformed most other sectors of comparable credit quality due to their high cashflow carry.
Outlook:
We expect U.S. agency MBS credit spreads to tighten post-election as volatility declines, reversing the spread widening in October, but we expect credit securitized spreads to stabilize at current 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, 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, however, we expect this to lessen as we believe rates will decline in the coming months. 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 remain slightly positive on Agency MBS valuations as they continue to remain attractive versus investment-grade corporate spreads and versus historical agency MBS spreads.