Different results on either side of the Atlantic

May was a rather mixed month for bond investors, depending on which side of the Atlantic they were invested in. While US rates rallied, with the 10Y coming down by 18 basis points, Euro rates rebounded, with the German 10Y rising by 8 basis points. This reflects the theme of the eurozone economy increasingly surprising to the upside relative to the US. We saw a number of US prints indicating a moderation in the US economy, with downside surprises on housing and PMIs, although consumer spending remains strong. In the eurozone, we saw good PMI data, confirming improving economic activity.

Corporate credit also performed well, reflecting positive equity market performance. Spreads in EUR IG credit were mostly flat, with only a small tightening of 5 basis points, but EUR HY continued to tighten substantially, by some 20 basis points.

Emerging market debt also performed over the month, despite election results in Mexico, South Africa and India that in various ways delivered outcomes seen as challenging. Spreads were largely flat, but total returns offered by the segment still firmly positive – demonstrating just how important carry is as a return driver in this higher rate environment.

We also witnessed the first rate cuts in this cycle in G7 economies, first in Canada and then, several days later, in the eurozone. Markets were certainly primed for these moves, and all eyes are now on the further trajectory and what the Fed will say and do.


US rates: mixed messaging from the Fed

The new Fed “dots” came in hawkish, pencilling in only one rate cut this year – after a downside CPI surprise that had sent a dovish signal to markets earlier the same day. At the same time, Jerome Powell suggested that most members had not updated their views based on the very latest data, and reiterated the message that the Fed is “data-dependent”. This gave markets the signal they needed to largely ignore the hawkish tone: markets ended the trading day pricing more rate cuts than the day before.

The question of the extent of rates cuts is now closely tied to their timing. If this May downside CPI surprise is confirmed through August – four months in a row – it could give the Fed the reasons it needs to cut in September, followed by another cut in December.

“Super-core” inflation fell off again in the May reading, although is still substantially up from the end of last year. However, we see the labour market as being the key indicator that disinflation is likely to continue after having stalled for several months. So far, disinflation has been driven by core goods – with core services and housing more stubborn. A falling QUITS rate, which suggests a further deceleration in wage growth towards the 3.5% level (consistent with the Fed’s 2% inflation target in the medium term) over the coming months, should result in continued disinflation in core services. We also think the housing market will cool down. Price increases on new leases, a good leading indicator of owners’ equivalent rent, has nearly fallen to 0. It is understandable that the Fed does not want to give the “all clear” to markets and emphasises caution – however, we continue to see the necessary economic trajectory in place that could justify a September cut.


The first ECB cut was a given – what comes next?

The ECB proceeded to its first rate cut in five years, as it had been signalling for months. Any other outcome would have been a major surprise. In terms of the tone, Ms Lagarde emphasised “data dependency” and did not commit to a particular trajectory. Inflation and growth assumptions for 2024 and 2025 were also revised upwards – though inflation expectations are still lower than they were in December 2023. With markets divided between one more or two more cuts this year, we retain our view that two is the more likely scenario. We see the disinflationary trend as remaining in place. Therefore, we retain our OW on EUR rates overall, and look for lower levels to take profit from our position.

The European elections brought few surprises and the composition of the European parliament will not change radically. However, President Macron deciding to call a snap election in France based on his party’s weak results roiled spread markets, leading to a larger OAT-Bund spread widening than the country’s recent S&P downgrade. We are comforted in our UW France position, given uncertainty around the election outcome and possible difficulties in forming the government thereafter.

The concurrently held elections for the Belgian Parliament, on the other hand, produced an outcome that should allow for the relatively straightforward formation of a government with fiscal prudence as a priority. As such, we are closing our UW Belgium position.

In addition to our long-standing overweight on Austria, we also like SSA names, including the European Union, where we see potential for further performance based on potential eligibility to sovereign indices going forward and increased liquidity. We see a margin for performance vs. France. We took profit on our positions in Baltic issuers. These have performed well, and given more constrained liquidity for these smaller issuers, we preferred to seize a good opportunity to exit.


EUR credit: spreads are still tight; fundamentals are still strong

With relatively little moves to IG credit spreads, we keep our neutral position. So far, this has also been a good earnings season for European firms, with clearly more beats than misses. This, combined with the benign macro and monetary backdrop, comforts us in retaining our neutral view despite relatively slim risk premia by historical standards.

We saw a bigger move in HY credit. To some extent, this was driven by restructuring rumours in a select number of names with a high index weight. However, at these levels, combined with the relatively high weight of French issuers in the market, we prefer to move to a more prudent position. Compared to USD HY, we still retain our preference for EUR HY – though to a lesser extent. Quality is still higher in the EUR space, but euro-hedged yields of USD bonds are no longer vastly lower than those of EUR bonds. With attractive valuations and a good backdrop for equities, we also move to a more positive view on convertible bonds.

In the context of the snap elections, we generally keep a very close eye on French names, especially banks and those with close ties to the state – again underlining the importance of bottom-up issuer selection.


In emerging markets, a busy election calendar

May saw elections in three of the most important EM countries, both in terms of population and economic weight. In Mexico, a larger-than-expected win for Claudia Scheinbaum, an ally to term-limited incumbent AMLO, caused nervousness among investors, as her win may give her the mandate needed to implement investor-unfriendly judicial reforms. In South Africa, the ANC could not secure an outright majority, potentially opening the door to a coalition with the far left. In India, PM Modi’s BJP won the election as expected, but with a slimmer majority than expected. In the wake of a strong US rates performance, treasury-sensitive investment grade issuers outperformed.


FX opportunities concentrated in EM; with DM macro and monetary policy largely priced

We have returned to a neutral position on developed market currencies, including USD and relative value trades we held between AUD/CAD, NOK/EUR and EUR/GBP.

We took profit on our AUD vs. CAD trade after the Canadian rate cut and our short EUR vs. NOK. We also closed our EUR vs. GBP long after the announcement of snap elections in France. We also took profit on our long HUF vs. PLN position, both because we see the Polish central bank continuing to be rather hawkish and in light of ongoing tensions between Hungary and the EU.

In EM, we keep our longs on INR and IDR, which are delivering very attractive carry, and on TRY, which in addition to carry, offers potential thanks to a re-normalisation of economic and monetary policy in Turkey.

We also keep our short CNY vs. USD, which we also hold as a partial hedge with positive carry against potential further downward moves in Chinese government bond yields, given our UW position on Chinese rates.

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