May and the first two weeks of June saw a good performance from risk assets, while rates assets underperformed. After April’s lows, a (relative) thawing in trade rhetoric and delays to the introduction of some tariffs caused recession fears to recede and increased global growth prospects. In bond markets, credit spreads rallied back to nearly their pre-April levels. An accelerating news cycle seems to be leading market participants to quickly move on from bad news. Avoiding the worst-case scenario appears to be justification enough for many to return to a constructive stance. We also note a relative absence of a market reaction to other events relevant to the bond market. The Moody’s downgrade of the US was not unexpected and the market largely took it in its stride. The “Big, Beautiful Bill” – which offers no credible path to reducing the budget deficit – passed after the US 10Y rate had already peaked.
Two weeks into June, we witnessed an escalation of hostilities in the Middle East, as Israel launched air strikes against Iranian nuclear facilities and its senior military leadership. Several days later, markets are largely shrugging the episode off. Conflict in the Middle East has historically had an outsized influence on markets relative to the region’s weight in the world economy because of its repercussions on oil prices. However, global energy markets today have seen structural shifts, with the US now the largest producer and Europe having somewhat reduced its dependence on fossil fuels.
Our fair value model suggests that US 10Y rates are currently quite attractively valued, trading materially above our fair value estimate. At the same time, the probability of recession has risen sharply. Soft data remains weak, and hard data is also showing some deterioration. Labour market risks are increasing, with narrow job gains and weakening confidence indicators. Inflation prints are, so far, surprisingly soft – although tariffs will likely push CPI higher. While this is a negative element in our framework, we also think it is largely priced in. The market currently prices 75 basis points of rate cuts by next April, but the Fed may very well be compelled to go further if the labour market weakens too much. Investor positioning is also more supportive, with CTAs and asset managers less long or neutral, giving room for inflows. We prefer to be positioned on the 2- and 10-year segments. The 2 – 5 – 10 butterflies are again trading at levels almost as low as summer 2024, when the overall curve was still much flatter. This indicates that the 5Y is comparably expensive, as many investors likely preferred to concentrate their exposure on the belly of the curve rather than longer tenors. We also prefer to avoid the very long end due to supply risks and steepening exposure. Nevertheless, Euro-based investors should note that on a hedged basis, USD rates are not attractive relative to bonds denominated in EUR. Combined with our prudent outlook on the dollar, it is therefore important to note that the downwards directionality of rates is not the only consideration for most European investors.
We are neutral on JPY rates overall, while we are long at the very long (30Y) end and short on shorter-dated paper. We see the front end as vulnerable due to the potential for the Bank of Japan to become less dovish if other global central banks pause or delay easing, reducing pressure to protect the value of the yen. On the other hand, the long end of the curve offers very attractive value, especially on a currency-hedged basis. Currently, 30 year JGBs hedged offer a EUR-hedged yield of 4.63%; while a the German 30Y is offering “only” 2.97% (as of 17 June). The difference is even more dramatic for USD-based investors. This could also entice flows from foreign investors, in addition to domestic factors that may also be supportive – increased investments from Japanese life insurers and possible changes in issuance patterns by the Ministry of Finance.
After the ECB’s June meeting and rate cut, we maintain our overweight position on EUR duration. We now no longer expect more rate cuts than the market in our base case scenario and therefore don’t think monetary policy will be as supportive going forward. Our expectation is that the central bank will pause in July and cut again (for its final cut this year) in September. However, the business cycle is still supportive – as are technicals, with most countries well advanced in terms of issuance this year (above 60%). Inflation should reach levels well below target in H1 2026, although this is probably largely priced in. On a per-country basis, we took partial profit on our long position on Bulgaria after the announcement that the country is expected (with near certainty) to join the eurozone and the strong relative performance we have seen. We continue to be cautious on France and constructive on Spain.
We are upgrading our views on both USD and EUR IG credit to neutral, reflecting improved confidence in the asset class despite recent spread tightening. Corporate fundamentals in Europe and the US are solid among IG issuers, while companies have shown resilience and continue to exhibit strong balance sheets. Ratings drift remains positive, with more upgrades than downgrades. Demand for EUR IG credit in particular remains strong, especially as ECB rate cuts and the steepening yield curve are pushing some investors out of money markets and floating rate instruments and into fixed income. We also expect inflows to continue as investors seek yield in a low-rate environment. High-quality investment grade corporates are increasingly seen as relatively safe investments, sometimes even more so than sovereigns. For example, lending to a company like Microsoft (AAA/Aaa) or Sanofi (AA/Aa3) may be perceived as less risky than lending to certain governments. We are not ready to move to an overweight, but any material spread widening could represent an opportunity to do so if fundamentals don’t deteriorate.
We are also upgrading AT1s back to a neutral position. European banks are in strong financial health, with robust capital buffers and solid earnings. Share prices for banks are around all-time highs, boosting overall confidence in the sector. With yields comparable to HY for a sector in much stronger health than the HY average, we see the risk-return profile of AT1s as relatively attractive. We also see some potential for event-driven performance from M&A activity.
In HY, in contrast to IG, fundamentals are deteriorating, particular in the autos sector, which is under pressure from structural changes. Other sectors like energy and retail are also showing signs of weakness. Spreads have tightened substantially and are now close to historical highs, and overall, we don’t think these valuations currently compensate adequately for risk. Therefore, we remain negative on the asset class, but still slightly upgrade our view based on market technicals.
We upgrade our view on both emerging local rates and emerging FX. With slowing growth and declining inflation across EM economies, supported by a weak dollar, EM central banks have room to cut rates without triggering currency depreciation. Indeed, so far EM FX has shown resilience post liberation day. Absolute yield levels in local markets remain attractive, especially in Latam. We have been observing inflows into local currency funds, albeit somewhat at the expense of hard currency funds. In hard currency debt, spreads are in the middle of what we perceive as the current fair value range, i.e. between 300 and 400 bps. Spreads are still tight, and the growth outlook is less supportive, but a weaker dollar provides breathing room.
The market has moved to a “long everything vs. USD” stance, and we believe this will remain the case in the foreseeable future. This is further supported by an ECB that may be less aggressive in cutting than expected before the June meeting, although we had already observed a “decoupling” of rates differentials and relative EUR/USD performance.
On traditional “risk off” currencies, we maintain a short CHF vs. JPY. The inflation difference has widened, with Switzerland moving towards deflationary territory. These currencies can be expected to react in a similar manner to any generalised sell-off of risk assets.
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