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What happened last week?
The Federal Reserve’s balancing act continues. Chair Powell set the tone last week, emphasizing that while inflation is inching closer to the Fed’s 2% target, the journey is anything but smooth. With the U.S. economy outperforming expectations, Powell argued there’s no rush to lower rates, highlighting ongoing uncertainties about the elusive “neutral rate.” This deliberate approach reflects concerns over structural economic shifts and the potential inflationary impact of fiscal and trade policies, particularly with President-elect Donald Trump’s agenda, which includes tariffs and restrictive immigration measures. Fed officials shared this cautious optimism. Kansas City Fed President Schmid underscored the challenge of determining the endpoint for rate cuts amid structural changes, while Dallas Fed President Logan warned that the neutral rate might now be higher than pre-pandemic levels. Chicago Fed President Goolsbee projected that rates could be significantly lower within 12-18 months, provided inflation continues to decline. Markets, however, are divided, with the probability of a December rate cut slipping to 55% from 65%. Across the Atlantic, the European Central Bank (ECB) faces its own challenges. Schnabel called for agility, emphasizing short-term interest rates as the primary tool in volatile conditions. Vice President De Guindos pointed to weaker-than-expected eurozone growth and risks from potential U.S. protectionist policies. ECB Governing Council member Rehn supported a December rate cut, citing ongoing disinflation and weak growth. However, the market remains uncertain, assigning a 25% chance to a larger 50bps cut. In the U.K., Bank of England MPC member Mann offered a surprising twist, signaling readiness for significant rate cuts once inflation stabilizes. Known for her hawkish views, Mann reflected broader uncertainties tied to fiscal stimulus, with markets now expecting no change in December. From Washington to Frankfurt to London, central banks are signaling caution. The road to lower rates remains paved with complexities, from inflationary risks to shifting neutral rate levels. As policymakers tread carefully, the stakes for future decisions are higher than ever.
The credit market faced headwinds last week, mirroring the S&P 500's 2% decline, with U.S. credit spreads widening amidst rising Treasury yields. After reaching a record low of 74 bps two weeks ago, U.S. Investment Grade (IG) spreads widened by 4 bps to 78 bps. This combination of wider spreads and negative Treasury performance hit the Vanguard USD Corporate Bond ETF, which fell by -1.2% over the week. Despite this setback, IG corporate bond ETFs attracted $1.1 billion in inflows, the highest in six weeks, signaling continued investor interest. However, caution is warranted as the spread between BBB and BB-rated bonds remains exceptionally tight at 62 bps, well below the historical average of 170 bps, highlighting strong risk appetite but also potential complacency. In the High Yield (HY) space, CCC-rated bonds demonstrated relative resilience, widening by just 4 bps compared to 10 bps for BB and B-rated bonds. The iShares Broad USD High Yield Corporate Bond ETF declined by -0.7%, outperforming IG counterparts due to its shorter duration. However, HY flows have been inconsistent, with a $744 million outflow last week following a $3 billion inflow the previous week. In Europe, IG credit spreads remained remarkably steady at 100 bps, benefiting from solid performance in European rates. The iShares Core Euro IG Corporate Bond ETF gained +0.3% over the week. Similarly, European high-yield spreads held firm at 322 bps, leading to a flat performance for the iShares Euro HY Corporate Bond ETF. Among high-beta segments, bank subordinated debt outperformed corporate hybrids last week. The WisdomTree AT1 CoCo Bond ETF rose by +0.3%, while the Invesco Euro Corporate Hybrid ETF declined by -0.7%. The primary market was active, with BP and TotalEnergies issuing hybrid bonds across EUR, GBP, and USD, while Deutsche Bank, Société Générale, and NatWest launched AT1 instruments. In the U.K., Marks & Spencer's senior unsecured debt received an upgrade from Moody's to Baa3, transitioning to an IG rating, further strengthening the credit market narrative. While the market remains resilient, the combination of spread decompression and ongoing macroeconomic uncertainties will likely keep investors cautious moving forward.
The U.S. bond market remains gripped by volatility, as evidenced by the MOVE Index, the "VIX of bonds," stubbornly hovering above 100. Last week, the 10-year Treasury yield retested the 4.5% level following stronger-than-expected macroeconomic data before closing at 4.43%, up 13 basis points from the previous week. This ongoing yield climb underscores the pressures on U.S. Treasuries, driven by the resilient American economy and fiscal uncertainty tied to the incoming Trump administration’s policies. Treasury performance reflected this challenging backdrop. The iShares USD Treasuries ETF dropped -0.4%, while longer-dated bonds bore the brunt of the underperformance, with the iShares 10-20 Year Treasury Bond ETF losing -1.8%. Treasury Inflation-Protected Securities (TIPS) also struggled, as the iShares USD TIPS ETF declined -1% over the week. The combination of economic resilience and uncertainty over fiscal deficits has kept Treasuries under pressure, prompting investors to favor riskier assets. Across the Atlantic, the outlook is markedly gloomier, enabling European bonds to outperform their U.S. counterparts. Reflecting this divergence, the yield gap between 10-year U.S. Treasuries and their European equivalents (EUR swap rates) widened to 215 basis points, the highest level since 2018. The 10-year German Bund yield tightened by 2 basis points to 2.35%, while other European government bonds delivered stronger performances. Notably, the 10-year French yield narrowed by 4 basis points, and the Italian 10-year yield saw an impressive 13-basis-point drop. Against this backdrop, the iShares Core EUR Govt Bond ETF posted a robust gain of +0.6% last week, highlighting the relative strength of European bonds. Elsewhere, government bonds in the U.K. and Switzerland were less eventful. The Vanguard U.K. Gilt ETF slipped a modest -0.1%, while the iShares Swiss Domestic Government Bond 7-15 ETF ended the week flat. The story of rates last week was one of divergence: U.S. Treasuries continued to face headwinds, while European bonds, buoyed by a weaker economic outlook, found room to rally. As 2025 looms, these trends will be critical for shaping global bond market strategies.
Emerging market
Emerging market (EM) bonds faced a challenging week, weighed down by rising U.S. interest rates and a stronger dollar. Despite stable spreads—257 bps for EM sovereigns and 198 bps for EM corporates—the pressure from external factors led to negative returns. The iShares Emerging Market Sovereign Bonds ETF dropped -1.5%, while the iShares Emerging Market Corporate Bonds ETF declined by -0.6%, cushioned slightly by its shorter duration. Local currency bonds didn’t fare much better, with the VanEck J.P. Morgan EM Local Currency Bond ETF also losing -1.5%, as EM currencies struggled against the strengthening dollar. The pain extended to Asian high-yield bonds, which were down -0.6% last week, dragged lower by ongoing troubles in China’s real estate sector. Chinese real estate bonds in particular fell by -1%, reflecting the sector’s persistent challenges despite repeated government efforts to stabilize it. In Mexico, the central bank opted for a cautious 25 bps rate cut, lowering its benchmark rate to 10.25% amid easing inflation and concerns over weaker growth. However, policymakers emphasized that monetary conditions will remain tight for the next two years, signaling no rush to a dovish pivot. Inflation forecasts were slightly revised, with headline inflation expected to hit 4.7% by Q4 and 3.0% by 2025. On the credit front, Moody’s affirmed Mexico’s Baa2 rating but maintained a negative outlook, balancing the benefits of nearshoring with risks tied to policymaking. Fitch and S&P also held steady with stable outlooks at BBB- and BBB, respectively. South Africa brought a glimmer of optimism as S&P upgraded the country’s outlook from stable to positive, maintaining the BB- rating. The economy is expected to grow at a healthier clip, with GDP projected to rise to 1.4% by 2025-2027 from 0.7% this year. Political stability under a new coalition government has bolstered confidence, with yields improving and the rand strengthening as a result. In China, the real estate saga continues. Country Garden, once the country’s largest developer, presented a restructuring plan for its $11 billion in offshore debt, facing a January 2025 court hearing. Negotiations involve potential haircuts and debt-to-equity swaps as the broader real estate sector continues to languish, with home prices and investments still declining despite government support measures. Finally, in Turkey, there was a mixed performance. Turkcell secured an upgrade from S&P to BB, signaling improved fundamentals, while Fitch downgraded Arcelik to BB-, citing operational challenges.
