September was another bruising month for investors in US and Euro rates. The US 10Y jumped higher than at any point in the past 16 years. Bank of America claims that losses sustained by lenders to the US government since summer 2020 are the biggest ever over a comparable time period – although we may legitimately question how analogous moves in the 19th century bond market are to today. It is no surprise then that investors are keen to say “enough is enough”, draw a line in the sand and find a good entry point – at the same time, news flow has not been entirely supportive of this, as the US economy has chugged along admirably. In a context of much higher rates and government deficits that remain high, markets are increasingly showing concern about government debt sustainability.
These conflicting signals have very likely been a contributing factor to the very high levels of bond market volatility we have seen for over a year now. In 2023, volatility[1] has been at its highest since the GFC after the US 10Y had already broken past 4.2% – up from just above 0.5% in the immediate aftermath of the first Covid shutdowns. Although the likelihood of another rate hike has faded into the background in both economic areas, markets pricing the impact of “high for longer” became the dominating theme as expectations for rate cuts have been scaled back.
The American consumer: No longer the “Spender of Last Resort?”
The US economy has shown remarkable resilience in the face of a very rapid hiking cycle. In an environment where borrowers had become accustomed to very low cost of capital thresholds, the sudden tightening of financial conditions might well have been expected to lead to significantly greater economic pain.
We see two main explanations behind why macroeconomic data has continued to come in strong and in many cases surprise to the upside. First of all, many households were able to accumulate significant savings during the pandemic. These reserves have continued to fuel consumption until recently, but all but the wealthiest fifth of the population have now probably exhausted these piggybanks. Secondly, fiscal largesse in a strong economy has been nearly unprecedented: in spite of a strong economic recovery after Covid, deficit spending has continued to fuel the economy.
With fewer savings, increasing interest on credit cards, auto loans and mortgages, and the resumption of payments on student loans, the American consumer is likely to be only squeezed further. Although non-farm payrolls recently came in with a very strong print, early signs such as temporary help and the number of people for every job opening advertised are signs of a cooling labour market.
A cooling economy should support the Fed’s job and bring down inflation and inflation expectations. From a pure valuation perspective, US rates certainly look very attractive.
We keep our overweight position on US rates, but prefer to come back to a neutral position on the 10Y tenor and concentrate at 5 years. We like the belly of the curve, as it provides a greater degree of protection against surprises in monetary policy and expectations.
The European economic outlook is unsupportive of higher rates
In the US, we still see a “soft landing” as the most likely scenario, with a risk of higher rates tipping the economy into a recession. In Europe, our outlook for the economy is less optimistic – a weak growth environment is our base case. Although rates on this side of the Atlantic have also suffered recently, we fundamentally retain our conviction in a long position on EUR duration. After hiking to 4%, the ECB has hinted that this was probably the last hike of the cycle. We also keep our steepening bias and move a part of our overweight from the 10Y to the 5Y in light of our expectations on monetary policy. At the very long end (30Y), we are underweight, as the end of PEPP reinvestments should also put upward pressure on rates as supply and demand dynamics deteriorate.
We take partial profit on UK rates
The UK stands out as the only G4 economy that has recently experienced a significant upward move in unemployment. In light of the resilience that the eurozone labour market has shown despite anemic growth – joblessness having recently fallen to the lowest figure ever since the creation of the common currency – we see this as a strong sign that the UK economy cannot support rates at the current level. Indeed, the market seems to have come around to this view rather rapidly, with rates moving down. As a result, we took partial profit on this outperformance. We still believe that UK rates have room to fall further and stay overweight, but now with positions in line with the US and EU.
Investment Grade credit: Good yields, spreads are a different story
In EUR investment grade credit, spreads are still largely in line with the post-GFC average. Although we do not anticipate any particular problems for European investment grade firms to refinance at higher rates or to maintain revenue to keep up debt service obligations, we are in an environment with a greater concentration of potential risks, from geopolitics to earnings surprises and everything in between. Headline yields are nonetheless still attractive, and we continue to feel comfortable with names with sound business and financial profiles, particularly on short-dated credit. Nonetheless, we would like to see higher spreads becoming more positive on the asset class overall and stay neutral for now.
In the US, spreads are, simply put, far too tight for us to see value compared to investing in Treasuries. We would want to see a substantial widening before we come back to the asset class.
High Yield credit: We are prudent, but USD valuations have improved somewhat
We remain very careful on high yield credit, as fundamentals have likely peaked and we expect to see a deterioration in the macro environment, credit metrics and ratings drift. In both EUR and US HY, spreads with IG credit are at very low levels – which we see as in no way reflective of the risks the segment will face in light of refinancing at much higher levels and possible topline pressure on firms. Nonetheless, given the recent underperformance of US HY, we tactically take a somewhat less negative view, as valuations have moved a little closer to levels we would see as fair. Globally, the theme of dispersion between issuers is emerging with increasing clarity. This should nonetheless provide opportunities to pick strong firms in the segment.
Emerging Markets: opportunities in select LC markets
Similarly, to US credit, spreads in HC emerging debt seem by no means sufficient compared to historical levels. The probable end of the Fed hiking cycle does not provide enough relief for us to like the asset class at these levels.
In local currency, the picture is more mixed. Although we see little potential for a substantial USD weakening against most EM currencies, we see value in local rates of countries where real yields are still very high, and which are now embarking on a cutting cycle after their historic hikes. In particular, we like Mexico, Brazil, Indonesia and India. Indian rates should further benefit from expected index inclusions, leading to demand from index funds.
[1] As proxied by the BofA MOVE Index, which tracks the implied volatility of US interest rate swaps.