What happened last week?

Central banks
Last week, the Federal Reserve reinforced its stance on maintaining higher interest rates for a longer duration to ensure inflation approaches their 2% target. Recent meeting minutes show unanimity in keeping rates elevated and revealed a thorough discussion on how best to scale down the balance sheet—a task reflecting the intricate balance required in current economic conditions. Atlanta Fed President Bostic pointed out that current monetary policies haven't slowed economic growth as effectively as in the past, suggesting a need for a prolonged period of high rates to manage inflation effectively. He noted that inflation's tapering has been gradual, recommending a cautious approach to any future rate cuts, not expected before the fourth quarter. Fed officials Mester and Collins echoed the need for more substantial data showing a consistent decline in inflation before even considering easing rates. On another note, Fed Governor Waller voiced concerns over unsustainable fiscal spending which could push the neutral interest rate, R-star, higher if U.S. Treasury supply continues to exceed demand, potentially leading to increased yields. Across the Atlantic, the ECB gears up for a rate cut in June, but the path for future reductions remains unclear, particularly with recent robust wage growth figures stirring caution. ECB Council member Vasle and Bundesbank President Nagel advocate for a measured, data-dependent approach to subsequent rate cuts, dampening expectations for rapid easing post-June. In the UK, the upcoming general elections have led the Bank of England to halt public statements by its policymakers, pushing back market expectations for a rate cut to possibly November. This global trend of central bank caution reflects a strategic patience, aligning with market views that now predict fewer and later rate cuts, with significant moves anticipated only towards the end of 2024.
 Credit

The U.S. corporate bond scene has been fairly calm lately, even with a bustling primary market activity. The spread for U.S. IG corporate bonds held steady at 87 bps for the fifth straight report, reflecting a stable environment. This calm has led to an all-time low in the 1-month volatility of the CDX US IG index. U.S. corporate bonds are seeing strong interest due to their attractive yields compared to stocks—currently at their most favorable since just before the 2008 financial crisis. This investor enthusiasm has propelled significant debt issuance, marking the first five months of 2024 as one of the busiest periods for U.S. IG bond offerings in the past 15 years. Despite this, the Vanguard USD Corporate Bond ETF saw a minor dip of 0.3%, largely due to shifts in interest rates. The high-yield sector is buzzing too, with spreads hovering around 300bps. Interestingly, a significant chunk—about 77%—of this year's U.S. HY bond issuance has been directed towards refinancing older, more expensive debts, showcasing a strategic shift in the market dynamics. Amidst this backdrop, a notable incident occurred in the CMBS market, where AAA-rated note holders faced a rare 26% loss on a major office building in New York City. This event, though isolated, has raised eyebrows but isn't expected to shake the broader CMBS market, which remains stable. In Europe, the credit market continues to be buoyed by strong technical support, high issuance volumes, and consistent inflows. May is on track to record the highest volume of European HY deals for the month in five years, nearly doubling the volume of the past five years. Despite the influx of new deals, credit spreads have compressed impressively. According to BofA, nearly a quarter of the Euro HY market now trades below 150bps, with almost 11% of Euro HY tickers tighter than the average BBB spread of 125bps, and about 5.5% tighter than the average high-grade spread of 108bps. The tightest 25% of BB tickers are at post-GFC lows in spread. The iShares Core Euro IG Corporate bond ETF shed 0.2% last week, impacted by rising interest rates though credit spreads tightened slightly. Meanwhile, the iShares Euro HY Corporate bond ETF edged up by 0.1%, with credit spreads reaching their lowest since February 2022 at 335bps. The standout performer was the Invesco Euro Corporate Hybrid ETF, which gained 0.6%, benefiting from Moody’s recent methodology update for hybrid notes. This update has introduced a new category of hybrid instruments with features like shorter maturities and limited coupon deferral, potentially enhancing credit ratings and reducing issuance costs, marking a significant shift in the hybrid market landscape.

Rates

Last week in the government bond market, things stayed quiet until a jolt from the U.S. PMI figures stirred the scene. The Composite PMI index leaped to 54.4, its highest since April 2022, indicating stronger economic activity than many anticipated. This triggered a uniform uptick in U.S. Treasury yields by about 7 bps. By week's end, the 10-year U.S. Treasury yield settled at 4.47%, a modest rise of 5 bps. Notably, the yield curve hit its most inverted point of the year, with the 2-year yield climbing 12 bps to 4.95%. Despite these dynamics, the iShares USD Treasuries ETF dipped slightly by 0.2% over the week, though it's still up 1.5% for the month. Investors eyeing a steeper yield curve have been thwarted by the Fed’s cautious pace on policy normalization. Market volatility has calmed, hitting its lowest since early 2022, thanks in part to upcoming adjustments in Fed's quantitative tightening and new liquidity-enhancing measures (bond buy back program). Looking ahead, the Treasury market is bracing for a hefty auction day with $69 bn in 2-year notes and $70 bn in 5-year notes set to hit, alongside the closely watched Core PCE inflation data. Across the Atlantic, European yields were nudged higher by unexpectedly strong wage growth data, particularly from Germany, where back payments boosted figures above forecasts. This led to the 2-year German yield breaking past 3% for the first time this May, ending the week up by 10 bps. Consequently, the iShares Core EUR Government Bond ETF retreated by 0.3%. However, peripheral European yields stayed stable, with no notable shifts in spreads. In the UK, Gilt yields rose sharply following less dramatic drops in core inflation than expected, coupled with political uncertainties. The 10-year yield increased by 14 bps to 4.26%, and the 2-year by 20 bps to 4.50%, reducing expectations for a rate cut in June. Lastly, in Japan, inflation and currency depreciation pressures are brewing. With core inflation at 2.4% and the yen weakening, the market is on alert for possible preemptive actions from the Bank of Japan, potentially even before the summer. This pushed the 10-year yield over 1% for the first time in over a decade, and the 30-year yield to 2.17%, levels not seen since 2011. These developments suggest a potentially more active stance from the BoJ in the coming months.

Emerging market

Last week, EM corporate bonds showed a bit of strength, managing a small gain of 0.1% despite rising global interest rates. Interestingly, EM corporate bond spreads have tightened to levels not seen since July 2007, dipping to around 200 bps. This shows a growing confidence in emerging market debt. Over in Asia, investment-grade corporate spreads hit a record low of 75bps. This tightening has been helped along by a quieter primary market and a significant pullback in foreign debt issuance by Chinese companies. In fact, this year saw the lowest dollar bond issuance by Chinese firms outside China since 2012, totaling just $19.8 billion. More Chinese companies are choosing to borrow domestically thanks to much lower financing costs at home, where the best corporate notes offer yields around 2.3%, a bargain compared to the global average of 3.9%. There’s a buzz in the Chinese offshore convertible market too. JD.com just issued $1.75 billion in bonds, and Alibaba is eyeing a hefty $5 billion issuance soon. Meanwhile, in the Gulf Cooperation Council (GCC) area, Qatar stepped back into the bond market for the first time in four years with a $2.5 billion deal. This year has been a busy one for the GCC, with significant bond sales from Saudi Arabia, Abu Dhabi, Bahrain, and Sharjah. Turkey held its key interest rate steady at 50%, betting that inflation will begin to ease next month. Over in Chile, the central bank cut its policy rate by 50 bps to 6.00%, signaling more cuts could be on the way. Paraguay’s central bank held its rate at 6% for the second time in a row. Indonesia kept its rate at 6.25%, after a surprise hike last month, promising to keep supporting the rupiah, which suggests no further rate hikes soon. In India, there’s a bit of drama as Goswami Infratech Pvt., known for issuing the country's largest high-yield rupee corporate bond, got creditors to agree to delay a bond payment due this month until September 30. This scenario highlights some ongoing risks in emerging markets, especially as more global private credit investors get involved.


Our view on fixed income (May)

Rates
NEUTRAL

For government bonds with maturities of less than 10 years, we hold a neutral stance. This position is supported by the presence of high real yields, an anticipated peak in central bank’s tightening, a shift towards disinflation, their relative value when compared to equities, and an improvement in correlations. On the other hand, we exercise caution towards bonds with maturities exceeding 10 years. The presence of an inverted yield curve and negative term premiums diminishes their appeal, especially amidst ongoing interest rate volatility.

 

Investment Grade
NEUTRAL
We are more cautious on IG corporate bonds. The sharp tightening in credit spreads, reaching lowest level since 2021, has considerably reduced the margin for safety in credit. Spreads now represent less than 20% in the total yield of an investment grade bond. This “price to perfection” encourages us to be more vigilant in this segment.
High Yield
NEGATIVE

High Yield (HY) could come under pressure in this uncertain environment. Recession fears, expectations of higher default rates and one of the most aggressive monetary policies are expected to weigh on this segment. The spread of U.S. HY bond narrowed below 300bps, its tightest point since January 2022. This current valuation of U.S. HY spreads implies modest default rates and the absence of inflation slippage, or a near-term recession. We see more value on subordinated debts over High Yield. 

 
Emerging Markets
NEGATIVE
We have turned negative on Emerging Marke debt, driven by the strength of the dollar and rising US real yields. EM corporate spreads have reached very tight levels, which considerably reduces the margin of safety. Additionally, there are persistent negative capital flows and an increase in short interest in USD-denominated EM debt, indicating growing market pessimism. However, we still see value in bonds with maturities of up to 4 years and yields exceeding 6.5%.

The Chart of the week

Normalization of the bond volatility underway? 

20240524_cow

Source: Bloomberg

The MOVE index, an indicator which measures the US bond market volatility by tracking a basket of options on US interest rate swaps, is normalizing since the last weeks. Indeed the MOVE index has reached its lowest level since February 2022. Despite uncertainty about the path of the Fed monetary policy normalization, the latest Fed’s announcement of reducing their QT starting on the 1st of June and that the US Treasury department announcing a bond buyback program in the goal of improving the liquidity of the market. They will buy back off-the-run T-notes (older issues) which are considered the less liquid. 

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