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What happened last week?
The spotlight this week was firmly on the Jackson Hole symposium, where Federal Reserve Chair Jerome Powell provided significant insights into the Fed's policy direction. While the FOMC Minutes revealed that some members were already inclined to cut rates in July, Powell’s speech at Jackson Hole left little room for doubt. His remarks indicated a growing openness to lowering interest rates soon, particularly as inflation nears the Fed’s target and labor market conditions continue to normalize. This shift suggests a readiness to ease the previously restrictive monetary policy to support sustained economic stability and growth. Although the path to rate cuts is expected to be gradual, barring any significant deterioration in the labor market, the market is now pricing in four rate cuts by the end of the year—more than one cut per meeting. In Europe, the European Central Bank (ECB) is carefully evaluating its next steps. Having already implemented rate cuts in June, the ECB sees the September meeting as a critical moment to reassess its interest rate policies. Despite the initial cuts, stubborn inflation in the services sector and weak inflation and productivity data over the summer are keeping the door open for further reductions. ECB members emphasize the need for a balanced approach, focusing on patience and gradual policy adjustments to avoid damaging the economy. A recent slowdown in eurozone wage growth further strengthens the case for additional rate cuts. In the second quarter, negotiated pay increases slowed to 3.6% year-on-year, down from 4.7% in the previous quarter. This cooling wage growth, along with other economic indicators, supports the likelihood of an ECB rate reduction in September as part of its strategy to steer inflation toward the 2% target by the end of 2025. Meanwhile, in Japan, Bank of Japan Governor Kazuo Ueda signaled that further rate hikes remain on the table, maintaining a cautiously hawkish stance despite recent market volatility. Ueda emphasized that the policy rate remains very low when adjusted for inflation and reiterated the bank’s readiness to adjust rates if economic conditions align. This message, which aligns with Deputy Governor Shinichi Uchida’s earlier comments about avoiding hasty rate hikes amid market instability, led to a moderate rise in the yen against the dollar. Ueda’s careful communication suggests a continued path towards policy normalization, though with a deliberate approach to avoid unsettling the markets.
The ongoing normalization of monetary policy, paired with a soft-landing scenario, has created an ideal environment for credit markets. After nearly two years of anticipating a recession, credit investors are now benefiting from both declining interest rates and tightening credit spreads. In the U.S., investment-grade bonds saw their spreads tighten to 94 bps, while yields dropped to their lowest levels since February 2023, falling below 5%. This favorable backdrop led the Vanguard USD Corporate Bond ETF to post an impressive 1% gain for the week. In the high-yield sector, spreads also tightened, with the Bloomberg U.S. Corporate High Yield Index ending the week at 312 bps. The iShares Broad USD High Yield Corporate Bond ETF continued its strong performance, gaining 0.7% last week and bringing its year-to-date return to nearly 7%. Across the Atlantic, European credit markets delivered solid, albeit less dramatic, performance compared to the U.S., largely due to more stable interest rates and relatively flat spreads. However, European credit saw robust inflows, bolstered by the weaker U.S. dollar, with €2.3 billion flowing into investment-grade bonds over the week, according to JPMorgan. The iShares Core EUR Corp Bond ETF and the iShares EUR High Yield Corp Bond ETF posted gains of 0.2% and 0.4%, respectively. Subordinated debt also saw positive momentum, with the Invesco Euro Corporate Hybrid ETF rising 0.5% and the WisdomTree AT1 CoCo Bond ETF up 0.2%. Year-to-date, both ETFs have delivered strong returns, with corporate hybrids up 6.8% and AT1 bonds up 6.5%. Overall, the combination of lower rates and tighter spreads continues to support the credit market, providing investors with solid returns across both investment-grade and high-yield segments. As central banks maintain a cautious approach to policy adjustments, the outlook for credit remains favorable.
This week concluded on a strong note for government bonds, with U.S. yields retreating by an average of 10 basis points. The Federal Reserve’s clear commitment to cutting interest rates at its upcoming FOMC meeting, combined with crude oil prices hitting their lowest levels since January, contributed to the 10-year U.S. Treasury yield dropping below 3.80%. Meanwhile, the front end of the yield curve saw an even sharper decline, closing at 3.91%. As a result, U.S. Treasuries delivered solid gains, with the iShares 3-7 Year Treasury Bond ETF advancing 0.6% and the iShares 10-20 Year Treasury Bond ETF rising 1.0%. Year-to-date, these ETFs are now up 3.5% and 3.1%, respectively. Interestingly, the U.S. yield curve (2s10s) is edging closer to moving out of negative territory, ending the week at -10 bps. After more than two years of inversion, the yield curve is now showing signs of steepening. Typically, a sharp steepening can signal an impending recession, but in this instance, the process has been more gradual. Market participants are hopeful that Fed Chair Jerome Powell can steer the U.S. economy towards a soft landing, avoiding the harsher effects of a downturn. Another notable development was the drop in the 10-year U.S. Treasury real yield to 1.66% on Friday, the lowest level of the year. This decline has been driven by several factors, including shifting expectations for future short-term rates, a cooling macroeconomic environment, and a reassessment of the neutral rate by market participants. U.S. inflation-linked bonds also benefited from this environment, with the iShares USD TIPS ETF gaining 0.9% last week, bringing its year-to-date performance to 3.8%. In Europe, German government yields remained relatively stable, reflecting the ECB’s anticipated easing of monetary policy. However, peripheral bonds performed notably well, with 10-year Italian and Spanish yields both declining by 7 bps to 3.56% and 3.02%, respectively. This favorable environment for European bonds led the iShares Core EUR Govt bond ETF to add 0.5% last week, pushing its year-to-date gain to 0.8%.
Emerging market
Is 2024 the year of the resurgence for EM Local Debt? Emerging Market local currency bonds have staged an impressive comeback, gaining around 6% since the start of Q3 and now up 2% year-to-date. This rally is a much-needed boost for an asset class that has lagged in recent years, especially when compared to U.S. Investment Grade corporate bonds (+5%) and U.S. High Yield bonds (+25%) over the past five years. What’s behind this resurgence? Two key factors stand out: the weakening of the U.S. dollar and economic challenges within Emerging Markets themselves. With the Federal Reserve potentially on the verge of its first rate cut, EM local debt could emerge as a significant beneficiary. However, geopolitical tensions and economic risks remain significant hurdles to sustained gains. In other EM segments, the iShares Emerging Market Corporate Bonds ETF posted a modest gain of 0.2% last week, with some spread decompression (+4 bps), while the iShares Emerging Market Sovereign Bonds ETF, benefiting from its longer duration and stable credit spreads, advanced by 1.1%. Over in Asia, Bank Indonesia (BI) held its benchmark seven-day reverse repo rate steady at 6.25%, as expected. The central bank also kept its overnight deposit and lending facility rates unchanged at 5.50% and 7%, respectively. BI Governor Perry Warjiyo mentioned that the bank still sees room for rate cuts in Q4 2024, with a focus on supporting further strengthening of the Indonesian rupiah (IDR) against the U.S. dollar. Asian high yield continues to outperform, with the iShares USD Asia High Yield Bond ETF up nearly 12% year-to-date, driven in part by Chinese high yield, which has gained 15% this year. Despite ongoing challenges in China’s real estate sector, the government remains committed to revitalizing the market. In an effort to address the property slump, China’s housing regulator has pledged to accelerate the conversion of unsold apartments into affordable housing, complementing broader initiatives to stimulate local economies and stabilize the real estate market. On August 26th, the People’s Bank of China (PBOC) hold the one-year Medium-Term Lending Facility (MLF) rate steady, after cutting it by 20 bps in July. However, another 10 bps cut in Q4 2024 is anticipated, reflecting the ongoing need for accommodative policy. Finally, it's worth noting the significant spread compression for Jaguar and Tata Motors following S&P’s upgrade to investment grade last week. Jaguar’s 5-year CDS dropped by more than 50 bps, highlighting the positive impact of the rating upgrade on these issuers.
