August was no by means all rest and relaxation for market participants. After an unsurprising June cut from the ECB, it was the Bank of Japan that delivered a surprise to markets, causing a spike in volatility in a normally relatively calm August – indeed perhaps exacerbated by lower liquidity. With an inflation at the highest levels in years, if not decades, the BOJ hiked rates. It triggered a sell-off in equities, with the Nikkei going down more than 12%, but recovering most losses the next day.
At the same time, changes in Nonfarm Payrolls rocked the markets, coming in far below expectations (114k vs 175k), with the unemployment rate increasing by 0.2% which heightened concerns of a more dramatic downturn in the US economy. The Jackson Hole conference brought no market moving news, but confirmed a relative shift of focus for the Fed from inflation the labour market. Chair Powell emphasised that labour markets are looser than pre-pandemic and are no longer a source of inflationary pressure. Secondly, he indicated there is “ample room” to cut rates and that the FOMC will do "everything we can" to support the labour market - a nod to the idea that rates can fall faster or further if labour market data softens further. Powell’s comments made it clear that September will mark the start of their easing cycle, and indeed this has been practically cemented by recent prints. This led some investors to anticipate over 100bps of cuts by the end of the year, implying at least one 50 basis point cut! We believe the Fed will not need to go this far but are certainly comforted in our base case of three cuts.
Overall, August saw positive performance from most major rates markets. US 10Y rates declined by 13 basis points, while German 10Y rates were nearly flat. Spreads in most corporate asset classes widened marginally, although with high intra-month volatility.
US rates continued to rally and outperformed other markets. After this, valuations appear more challenged. Supply and demand will also be a headwind in the short term. We also now think that US rates look relatively rich compared to EUR rates, based on how markets are pricing the terminal rate and what we would see as a fair difference for them. In terms of the economic outlook, the picture seems mixed. Markets are no longer doubting disinflation, and we would agree that the trend is firmly in place. All eyes are now on the labour market, and here we are seeing signals pointing in different directions. The “Sahm rule” has been triggered, but jobless claims have moved to the lower end of their recent range and the unemployment rate ticked back down in August.
What we may have been observing is indeed a relative slackening of the labour market due to high growth in labour supply as a result of very high immigration numbers, as opposed to a constraint on job creation. This clearly puts any relative looseness of the labour market under the caveat of possible public policy changes that could halt continued high immigration.
Fundamentally, we see core EUR rates as being close to fair value and share the consensus view of two more ECB cuts this year. We do still prefer to retain an overall positive grade and our steepening bias. Notably, we continue to see the dynamics in terms of inflation and growth as favourable to rates. While core inflation will likely remain above 2% this year, headline inflation should reach target. We may see downwards revisions to the ECB’s growth forecasts, with consumption and investment both negative in the Eurozone.
In the very near term over the next weeks, supply may still be a headwind, with substantial issuance coming to market in September. However, from October to year-end we expect supply and demand dynamics to be favourable to holders as most government treasuries will have satisfied the vast majority of their annual funding needs by then.
The picture on overall investor positioning on EUR duration is more mixed – cash bond investors seem to have trimmed much of their duration overweights while futures positioning still appears to be longer.
On a country-by-country basis, the nomination of a Prime Minister in France does not persuade us to close our underweight position. Parliamentary support risks being fickle and overall the political situation could remain volatile and bring further surprises. As such we continue to prefer an overweight to Spain, the strongest major Eurozone country in terms of growth dynamics.
On EUR IG credit, we retained our positive stance following the spread widening in the week of the “risk off” environment as a result of the Yen carry trade unwind. We benefitted from these better levels for participating in primary issues. True to our expectation, spreads have now come back down to their former, and indeed quite tight, levels. As a result, we prefer to return to a neutral view, essentially based on valuations. We note that company balance sheets and the earnings outlook remain benign.
The dollar has recently weakened materially against most other major world currencies after rallying strongly from June through August. The dollar can benefit both from upside surprises to the US economy, possibly tempering the Fed’s path forward – but notably also from downside surprises, acting in its “safe haven” and risk off capacity.
The landing zone for an environment favourable for USD shorts seems quite narrow given that the soft landing appears well priced. In either of the alternative scenarios (a recession or some unwind in the aggressive Fed cutting cycle) we should see a somewhat stronger Dollar. As such, and given we currently marginally favour Euro rates over US rates (which has been a strong driver of EURUSD in the recent past, as well as short USD positioning, we have a preference for long USD positions.
Between this short positioning and the fact that we may be at the low point of this “Dollar Smile” and hence choose to initiate a long position.
EM HC Sovereigns have seen a volatile two months, with spreads initially widening substantially before returning to similar levels as in July. Fundamentally, therefore our neutral position remains unchanged despite healthy fundamentals in terms of the macro picture and especially the US easing cycle we are entering into. For EM Corporates, we similarly see strong Corporate fundamentals (indeed better than most developed market peers) counterbalanced by, again, rich valuations.
In Local Currency, we may begin to see dynamics in terms of the global easing cycle that could be favourable to the segment but prefer to have more clarity and clearer catalysts.
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