March was a clement month for investors, with most asset classes delivering a positive performance. Equities were broadly positive and spreads in most risky fixed income asset classes tightened even further. At the same time, government bonds in most major markets saw modest declines in yields. Central bank action is still the narrative driving bond markets. G4 rates performance was led by the UK, where the 10Y fell by 19 basis points.
EUR investment grade in particular saw a strong performance, with HY lagging driven by a spread widening and lower rates sensitivity. The standout performer among major bond asset classes was HC EM debt, delivering a return of over 2% over the month.
Despite uncertainty around inflation, we see US rates as attractively valued, with market-implied neutral too high
We judge US rates as attractive based on valuations. While disinflation progress stalled in the first two months of the year and growth remains robust, the Fed has not substantially deviated from prior estimates of cuts this year. This tells us that they are quite keen to begin their cutting cycle, not wanting to be “behind the curve” as they were in the hiking cycle. Additionally, we believe they will be acutely aware that beginning their cutting cycle close to the upcoming US presidential election will be viewed as political interference in some quarters and, if data allows, would prefer to start with what is seen as quite a symbolic moment (the first cut) in the summer months, well ahead of the elections.
Based on the assumption of a summer cut alongside current forward energy prices, our fair value model shows current levels to be attractive. In addition, while it is absolutely possible that that the “neutral rate” has risen in recent years, we believe market-implied levels of close to 4% for the trough in the cutting cycle are too high, well above the Fed’s longer-term DOT.
We maintain our overweight on EUR rates as we continue to see value
Based on our expectations of fair value (based on inflation and monetary expectations), we maintain our overweight position on EUR duration. In particular, although we have observed some stabilisation of the growth picture, we believe that the disinflationary trend is firmly in place and should continue.
The ECB has been clear with its near-announcement of the first cut in June, with the pace and extent of following cuts continuing to be very much data-dependent.
We maintain our UW stance on French and Belgian debt vis-à-vis Austria. Despite some background rating risk, we ultimately don’t expect major spread widenings notwithstanding the recent French budgetary miss. Nonetheless, the balance of risks leads us to prefer underweighting these issuers on a relative basis vs. other eurozone issuers.
We also maintain our long Norway and UK spread trades vs. euro. While the disinflation process has been slower in the UK than the eurozone, we expect some “catchdown”, with headline inflation likely to fall to and below the BOE’s 2% target from April, remaining there for some months. The Bank’s governance structure may also permit some more nimbleness vs. its peers in the US and eurozone as far as rate cuts are concerned. Thus, we see a likelihood of more cuts relative to what is priced in markets for the UK compared to the eurozone.
We take profit on our OWs on EM HC sovereigns and LC, retaining a preference for EM Corporates
After our upgrade of EM HC sovereigns last month, spreads have tightened significantly. With value having been concentrated primarily in the HY segment, we have seen spreads here come in at 600 bps after having spiked above 1000, with index level spreads to Treasuries down to 200 bps. Excluding CCC-rated countries, spreads are at extremely tight levels.
In local currency markets, real rates are still quite high in most markets, esp. LATAM, but we also observe that the bulk of rate cuts are already priced in. Spreads to USTs have become tight here, too. With uncertainty around inflation and the Fed’s next steps, we prefer to be more cautious and return to a neutral view.
We continue to like Corporates where we see valuations as justified given overall healthy company fundamentals. This is further supported by a constrained supply picture.
EUR IG credit is still attractive, we have slightly upgraded our view on USD IG
Euro investment grade spreads to government remain tight. Relative to HY debt, valuations are more attractive given very tight BB-BBB spreads. However, we are comfortable with these levels because fundamentals are still supportive. The eurozone should still see positive economic growth as inflation recedes, whilst company balance sheets are also generally healthy. Rate cuts will provide additional relief. Technicals should also be supportive in the shorter term, as investor flows return to the asset class.
Valuations for US credit remain unattractive in our view given tight spreads. However, yields for EUR-hedged investors on US IG credit are less unattractive than they have been recently, with a hedged yield now slightly in excess of EUR IG credit, compared to levels that were over 100 bps lower in 2023. As a result, we have slightly upgraded US IG credit from -1.0 to -0.5. We have not upgraded US HY despite better EUR hedged yields, given the poorer quality of the USD HY market compared to EUR HY.
Diverging central bank policies lead to opportunities in currency markets
With EUR/HUF moving towards 400, we expect that the Hungarian authorities will seek to prevent the forint from weakening past this level, given the ramifications on inflation, and could slow the pace of rate cuts. In contrast, the Polish Zloty has performed well on the back of a hawkish central bank and reinforced confidence following the latest elections. As such, we initiate a long HUF vs PLN.
In Canada, inflation prints have surprised on the downside for two successive prints – the opposite of the US. As such, we believe the BoC is close to beginning its cutting cycle and we may see some deviation from the Fed in terms of the pace of cuts. This could put downward pressure on the Canadian dollar – a very different picture to Australia, where the Reserve Bank of Australia is likely to remain one of the most hawkish among developed markets, given the lower peak reached in the hiking cycle and still low real rates, supporting the Australian dollar on a relative basis.
In select eligible funds, we have also introduced a small long position on the Turkish lira. Despite continued very high inflation, currency carry is very high, and we see risks mitigated by a central bank with a governor and vice-governor adhering to orthodox monetary policy. The Finance Minister has also affirmed the goal of pursuing orthodox policy.