What happened last week?

Central banks
The Federal Reserve's monetary policy remains shrouded in uncertainty, with several members last week advocating a "higher for longer" stance on interest rates. A notable six Fed officials called for patience, requiring more robust data before considering rate reductions. Notably, Fed Governor Bowman does not anticipate any rate cuts this year, citing persistent inflation levels far from the Fed's 2% target. Similarly, Mary Daly of the San Francisco Fed acknowledges that while current rates are constrictive, they are necessary for longer to achieve inflation control, pointing out recent inflation upticks that delay potential rate cuts. Consequently, market expectations have adjusted, now foreseeing merely 1.6 rate cuts for 2024. In Europe, the latest ECB policy accounts highlight the growing divergence with U.S. monetary policy, noting an increasing interest rate differential that benefits the U.S. given its economic resilience. Despite this, the ECB is poised to commence rate reductions in June, with further cuts anticipated throughout the year, although the path beyond the initial cut remains fraught with uncertainty. Euro area markets have shown resilience amidst U.S. policy shifts, with the ECB vigilantly monitoring inflation risks, particularly from volatile food prices and Middle Eastern geopolitical tensions. Across the Channel, the Bank of England maintained its key rate at 5.25%, with two policymakers dissenting in favor of a cut amidst signs of slowing inflation. Market sentiment has shifted, now pricing in a nearly 60% likelihood of a rate reduction by June, previously anticipated for August, as confidence grows in diminishing inflation pressures. Meanwhile, Sweden's Riksbank took a decisive step by cutting its benchmark rate by 0.25% to 3.75%, marking its first reduction in eight years and signaling potential further cuts in late 2024. This move, following the Swiss National Bank's lead, fosters optimism for a Swedish economic recovery later in the year.

Credit

As credit spreads have narrowed significantly in recent months, the credit market remains largely driven by changes in interest rates, pending a significant credit market event. The slight premium on investment-grade corporate bonds, less than 1%, continues to attract investors. Bank of America reports that investment-grade bonds have seen their 28th consecutive week of inflows, setting a course for record inflows in 2024. This trend is supported by a positive outlook on the U.S. economy and corporate health, alongside a diversification drive away from U.S. Treasuries, which are currently challenged by increased supply, waning foreign demand, and the backdrop of a high U.S. fiscal deficit. Despite these factors, U.S. IG credit spreads remained stable at 87 bps this past week, leading the Vanguard USD Corporate Bond ETF to a modest weekly gain of nearly +0.2%. In the U.S. high-yield sector, the market softened slightly with credit spreads widening. The Bloomberg U.S. High Yield Index saw its spreads increase by 5 bps to 298 bps. Consequently, the iShares USD High Yield Corporate Bond ETF declined by 0.2% over the week. In Europe, the lower activity in the primary market combined with the ongoing economic recovery provided technical support to the credit market. European IG credit spreads tightened by 2 bps to 110 bps, while European high-yield credit spreads narrowed by almost 10 bps to 348 bps. The higher yield premium compared to the U.S. could benefit the European credit market going forward, especially if European economies continue their recovery trajectory. The iShares EUR High Yield Corp Bond ETF ended the week flat, while the iShares Core EUR Corp Bond ETF saw a slight decrease of -0.1%, impacted by rising European interest rates. Interestingly, last week marked a rebound in European contingent convertible (CoCo) bonds, driven by fresh market activity including a EUR 1.5 billion AT1 issuance from Banco Santander and a £1.25 billion AT1 issuance from Barclays. This revitalized interest provided a positive boost to the asset class, with the WisdomTree AT1 CoCo Bond ETF posting a gain of +0.8% over the week.

Rates

In the U.S., the Treasury market has adjusted to a reduced likelihood of interest rate cuts in 2024, following a series of Federal Reserve remarks hinting at a sustained cautious approach and signs of slowing economic momentum. The U.S. Economic Surprise Index has turned negative for the first time in a year, indicating a tapering of economic activity. This sentiment led to an increase in shorter-term yields, with the 2-year Treasury yield rising 6 basis points to end the week at 4.87%. Conversely, longer maturities saw modest gains; the 10-year yield remained nearly unchanged, just below 4.5%, while the 30-year yield decreased by 3 basis points to 4.63%. The Treasury market faced a significant influx of supply, with $125 billion in T-Notes issued this week. Notably, the 10-year auction saw lackluster demand, sparking a brief sell-off in rates. However, rates partially recovered following a weaker-than-expected U.S. initial jobless claims report. Both the 3-year and 30-year auctions attracted more favorable receptions. Despite these fluctuations, the iShares U.S. Treasury ETF closed the week nearly flat (+0.04%) and is up 1.1% month-to-date. In Europe, trading was subdued due to a shorter week and reduced liquidity. The iShares Core EUR Government Bond ETF ended the week down by 0.2%, influenced by a bear flattening where short-term yields rose by 5 basis points and long-term yields by only 2 basis points. The 10-year German yield continues to hover around 2.5%. The UK bond market experienced a positive week, bolstered by the Bank of England's dovish tone despite robust GDP figures. For the first time in three years, UK economic growth outpaced that of the U.S. and the eurozone, registering a 0.6% expansion in Q1. This growth spurred investor confidence, contributing to a 0.7% weekly gain for the iShares Core UK Gilts ETF.

Emerging market

In the realm of emerging markets, Latin American giants Brazil and Mexico are taking a more conservative approach to monetary policy due to internal economic pressures. Brazil's central bank made a cautious rate cut of 25 basis points, reducing the Selic rate to 10.50%. This smaller-than-expected adjustment was influenced by worries about unanchored inflation expectations and the credibility of fiscal policies, signaling that future easing may be limited. Similarly, Mexico’s central bank (Banxico) held interest rates steady at 11%, with a unanimous vote reflecting updated inflation forecasts that suggest a slower reduction in inflation than previously expected. Both central banks are navigating the dual challenges of persistent inflation and economic growth concerns, which has led them to adopt monetary policies that closely align with global trends, including the Federal Reserve's current approach. Despite their cautious stance, emerging market fixed income showed signs of improvement last week, with all major indices registering gains. Sovereign bonds in emerging markets rose by 0.5%, corporate bonds by 0.3%, and local currency bonds also increased by 0.3%. In Brazil, bonds from Braskem, the petrochemical giant, experienced a significant drop early in the week—nearly 5 points—after the Abu Dhabi National Oil Company (Adnoc) halted its negotiation process for acquiring a substantial stake in the company. However, these bonds managed to recover their losses throughout the week. The situation in China also reflects a cautiously optimistic outlook, particularly in the junk bond market, which saw gains of 0.6% over the week and an impressive 9% increase year-to-date. A recent meeting of China's Politburo indicated that President Xi Jinping is preparing to intervene significantly in the real estate sector to counteract a severe housing slump now affecting state-owned enterprises (SOEs). With property sales declining among SOEs, similar to earlier trends seen among private developers, Beijing plans coordinated actions to address the surplus housing inventory, with state-backed enterprises likely to benefit the most from these measures. Lastly, Turkey received a positive nod from S&P, which upgraded its long-term foreign currency debt rating to B+ with a positive outlook. The country's credit default swap (CDS) rates are well entrenched below 300 bps, currently standing at 283 bps, indicating a stabilizing economic perception among investors.


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

Is the China Junk Bond Market Signaling a Turnaround?

20240512_cow

Source: Bloomberg

This week's focus turns to the remarkable performance of the China junk bond market, which has seen a 1.4% increase since the beginning of May and an impressive year-to-date rise of 8.7%. This surge is mirrored by a notable uptick in Chinese equities, with indexes climbing over 15% in the past month alone. Economic indicators have remained robust since February, highlighted by April's data showing a return to growth in both exports and imports—signals of recovering domestic and international demand that bolster hopes for China's economic stabilization. In the real estate sector, a significant contributor to the Chinese economy, there's a wave of policy relaxation. Following a directive from Beijing, major cities like Hangzhou have removed homebuying restrictions entirely, setting a precedent for others to potentially follow. This policy shift, aimed at accelerating the reduction of housing inventories, marks a significant move away from the gradualist approach previously employed and could inject new vitality into the market by simplifying the home purchasing process. Is the rebound in the China HY market indicative of a genuine economic recovery, or is it merely a technical correction? This trend, alongside easing real estate policies, suggests a potentially brighter outlook for China's financial markets.

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