October offered a mixed picture following a bruising first three quarters. The Bloomberg Global Aggregate Index was down 0.55%, driven primarily by losses in US Treasuries. However, investors in some segments of the credit markets, especially EUR HY, USD HY and to a lesser extent EUR IG did see positive performance. Most Inflation-Linked Bonds markets with the exception of the US also rallied on persistently high inflation.
In terms of G10 rates, the best performer by far was the UK, as gilts recovered. Switzerland and EMU peripherals completed the podium with positive returns, but at a very distant second and third. EMU peripherals significantly outperformed EMU core countries owing to the rally in BTPs, as the new Italian government was at pains to reassure markets. The US and New Zealand sovereign markets were the weakest performers. Riding on the coattails of strong equity market performance, EUR High Yield Credit delivered the strongest performance among credit and all major fixed income asset classes. Property far underperformed other sectors this month, compounding the underperformance suffered in the first three quarters.
Mixed signals from the fed: an inkblot test for markets
Persistently high inflation prompted the Fed to announce another 75 bps rate hike, bringing the Fed Funds rate to 4%. The speed of hiking is unprecedented in at least a generation. Indeed, the Fed emphasised the amount of tightening it has already undertaken to date, and reminded markets and the public that there will be a lag before monetary policy decisions feed through into the economy. While this could cause anyone looking for signs of a dovish inflection to prick up their ears, Jerome Powell was also at pains to make it clear that the Fed Funds rate would be higher for longer. The best interpretation of what might be seen as mixed messaging is that while the Fed may take its foot off the throttle when it comes to the speed of tightening, it has no intention of deviating from its destination. Consequently, the market now expects the Fed Funds rate to reach its peak somewhat later – but at 5%; a much higher level in absolute terms than what was expected until recently. Around that point, the Fed will likely pause to assess outcomes – both in relation to inflation and to growth. Indeed, there is a chance that we will not see a speedy turnaround back down to lower rates.
Ultimately, we believe that at current levels, US Treasuries are largely fairly valued and that markets are accurately pricing in likely Fed action. As we continue to progress through the hiking cycle, we expect the shorter end of the curve to become attractive again. This will, however, require a clear trigger – most likely in the form of sustained stable inflation. Currently, we are seeing signs of the beginning of the end of very high inflation. In particular, wages now also seem to be stabilising. At the same time, the business cycle has continued to show remarkable resilience: the Fed may ultimately be vindicated in its endeavour to engineer a soft landing for the US economy.
Emu duration: downside risks affirm our prudent stance
The ECB highlighted that substantial progress has already been made in its move towards monetary policy normalisation. Coupled with the market’s expectation of a recession in Europe, these signals could be favourable to investors in EMU rates. Nonetheless, a number of factors will likely conspire to maintain upward pressure in the near term. The ECB’s somewhat softer remarks came prior to another set of very high inflation figures. However, natural gas prices have now normalised somewhat, which will help calm inflation if the trend is sustained, and this will also likely reduce the severity of the economic slowdown.
A number of technical and supply-related factors also look likely to maintain upward pressure on yields in the short term. Banks will lose a tailwind to their earnings following the announcement of changes to the TLTRO programme – the ECB’s provision of loans to banks at very favourable terms. This will indirectly impact the government bond market by freeing up approx. €500bn of government and covered bonds, including approx. €100bn in German government bonds.
This abundance in the secondary market could be coupled with atypically high primary market issuance activity. A number of eurozone countries have lower cash reserves than usual. While for most countries, official figures as to how much of their deficits will be financed with reserves vs. new issuance are still outstanding, some “catch-up” seems likely. This could be exacerbated if the ECB continues to withdraw more APP support than expected. For the time being, it has not clarified what proportion of holdings will not be re-invested.
The antipodes as pacesetters?
Can we take Australia and New Zealand as bellwethers for monetary policy? While New Zealand in particular was one of the first developed economies to hike rates in response to the new inflationary environment, we can already perceive a dovish inflection. These economies are particularly sensitive to rate hikes given the prevalence of variable-rate mortgages. We also expect that Q4 inflation data will show a considerable slowing, as we see signs of this in activity data. The Reserve Bank of New Zealand could be one of the first to pivot. In light of this, we continue to have conviction in New Zealand rates.
Emerging markets: a mixed picture
While after recent routs, valuations in emerging market debt are showing some potential, plenty of risks remain. While a spike in oil prices could be a boon to producing countries, agricultural commodity prices remain stubbornly high. In Asia ex-China, inflation does not seem to have peaked yet, and central banks have some way to go in their hiking cycle. China appears committed to pursuing its Zero-Covid policy. Following a strong outperformance, valuations in Chinese government bonds also no longer appear attractive. In the near term, we don’t see any catalysts that would drive strong performance on these markets.
Nonetheless, on an idiosyncratic basis, we see value in some markets, notably in the CEE region, with Hungary and the Czech Republic.
With firms proving resilient, eur credit is attractively valued
We are constructive on EUR credit. Q3 earnings figures demonstrated that, so far, most firms appear to be able to pass through higher costs to their customers – it was generally a positive earnings season for European firms. Not least, with company fundamentals coming from a very strong starting point, there is a buffer for a limited degree of weakening. The technical picture is improving as some issuers will seize the November opportunity to tap into the new issue market, and the asset class is facing some inflows. We can expect less bond market volatility as central banks are signalling a slowdown in hikes as they approach their terminal rates. Right now, with EUR IG offering yields in excess of 4%, this market is an opportunity that is difficult to ignore. We are long on this asset class
We now take a neutral view on euro High Yield. Conversely, valuations on USD credit – particularly High Yield – still appear excessively rich at the moment.