Global equities fell for a third consecutive month in October and gold rallied against a backdrop of geopolitical risks, an under-pressure earnings season and a rising rates environment. October saw a yet another upward move in US Treasury yields, but importantly led by the longer end and therefore in a bear steepening trend. Investors in eurozone rates, on the other hand, benefitted from a bull steepening, with German 2Y rates falling by nearly 20 basis points. 10Y rates stayed mostly flat, with modest increases seen at the very long (30Y) end. Outside of the US, Japan and Australia were notable for rates moving upward across the curve – perhaps a reflection of the fact these are the only remaining major economies in which markets are pricing substantial rate hikes still to come. Credit spreads widened both in USD and EUR credit, and with more substantial widenings in lower-rated credit than investment grade.
US Rates: are we there yet?
We believe the sell-off was due to the continued strength of the US economy, illustrated by a very strong jobs report, robust retail sales as well as an upside surprise in growth, with a Q3 annualised GDP growth print of 4.9%, as well as the increase in the term premium. Investors required higher compensation for inflation uncertainty as well as concerns about supply. These concerns were somewhat eased last week as weaker than expected data kicked off November, and there was a positive surprise in terms of issuance, with the Treasury choosing to focus its larger supply requirements on the front end of the curve. Furthermore, the psychologically important 5% mark has thus far acted as something of a resistance.
We believe that on a medium term view, the current level of US Treasury yields are attractive. Fundamentally, we believe that after the most aggressive tightening cycle in a generation, monetary policy lag is still to be fully felt, as is the disinflationary course set to continue in the months ahead. In terms of curve evolution, historically bull steepening trends have occurred post the final Fed hike in the majority of cycles. We believe this will be the case in this cycle and while we have seen a significant steepening (outperformance of the front end) since the final (to this point) hike in this cycle, we think strategically that this can continue. In the short term, we are more prudent after the recent underperformance of the longer end, as we think some of these moves may reverse.
However, we note that volatility continues to remain high, and a calming of volatility might be required to see a more sustained rally.
EUR rates: more prudent on non-core at these levels
We continue to like core EUR rates and hold an overweight stance. Our fair value model suggests that with energy prices at current levels and an ECB deposit rate that we see as unlikely to be hiked again, there is scope for rates to fall again. At the last ECB meeting, there was no perceivable change in guidance except worries about the economy as dynamics are clearly weak. The deceleration of inflation is confirmed, and we expect that trend to hold. In the shorter term, however, we note that the supply picture will be more challenging, with substantial net issuance expected – though this could be counterbalanced by increased investor appetite at these levels and at this point in the cycle.
Following the recent spread tightening of BTPs vs Bunds to 190 bps, we prefer to adopt a more prudent stance on Italian rates. We saw some rating risk, in particular in the form of a change in outlook by Fitch. For 2024, uncertainty around PEPP reinvestments could also put upside pressure on Italian rates – in addition to net issuance that will in any event be unsupportive. Fiscal adjustments by the Italian government combined with deteriorating economic dynamics further complicate the picture.
Flattening of Australian rates
In most markets, we retain a steepening bias despite the recent rout in long-end rates. In Australia, however, we see a yield curve that is already quite steep. The Reserve Bank of Australia recently hiked rates again, but real rates are still clearly negative. The RBA indicated that they have a low tolerance to a return to increasing inflation, and in light of continued relatively strong inflation, growth and housing market, we see scope for the curve to flatten in the event of further hikes.
EM: value in select markets, but not attractive across the board
In light of slowing growth, inflation and central banks beginning to cut rates, we maintain a preference for local rates over hard currency credit. We like short- to mid-dated debt from India and Indonesia. This is largely a carry trade, with high yields in excess of 7% and 6.5% respectively.
Spreads of HC-denominated EM debt continue to be very narrow. However, we see select central European issuers as an exception to this, with Romanian debt in EUR offering good value, and we recently took part in an issue from Bulgaria.
Structural US dollar weakness
Historically, the most negative environment for the USD has been when there is a bull steepening of the US 2Y-10Y, which we see as the most likely scenario. Bull flattening is also usually a scenario unfavourable to the greenback. As, at this point, further hawkish surprises seem less and less likely, we see this as a good point to enter what is (still) a somewhat contrarian position, with the USD having become a crowded trade in the past few months.
We acknowledge that valuation metrics are typically poor short-term predictors of currency performance, but an overvaluation on PPP terms is nonetheless supportive of our long-term view. We see this as a longer term, structural trade. Currently, we are implementing USD vs. EUR and JPY, with the BoJ probably on the cusp of gradually switching to normalisation and the USD having lost momentum relative to EUR based on FOMC statements and weaker economic data.
More constructive on credit
We have become more constructive on EUR IG, US IG and EUR HY credit, but remain very prudent on US HY credit. In a soft landing scenario where bond rates perform and volatility stabilises, Investment Grade credit should rally. Attractive valuations with spreads somewhat above their 5-year averages, overall interesting yield levels, good credit quality and supportive technicals (less supply in the weeks ahead and more investor demand for carry) should support the asset class. We have a preference for financials and banks with European retail franchises, which offer on average 30 bps pick-up over non-financials.
Our notable change in view vs. EUR HY comes notably from a shift in the size of the asset class. We have a preference for BB issuers. Many rising star issuers are set to exit the space and enter IG indices, 23 on a year-to-date basis. The exercise of call options and low supply have created a squeeze on the asset class and reduced its average duration. The Ford upgrade has created a massive positive technical tailwind. This environment is supportive and this should continue and be more pronounced in the market’s higher quality segments.