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What happened last week?
Global markets were shaken this week by a dramatic plunge in Japanese equities on Monday, triggering a ripple effect across financial systems and prompting swift responses from major central banks. In Japan, the Bank of Japan (BOJ) reacted to the market turmoil by signaling a pause on interest rate hikes. BOJ Deputy Governor Shinichi Uchida underscored the importance of stabilizing the markets, while former BOJ board member Makoto Sakurai stressed the need for careful communication to prevent further disruptions. The BOJ’s response highlights the delicate balance central banks must maintain in a volatile global environment. In contrast, U.S. Federal Reserve officials continued to focus on inflation and employment data amidst the global uncertainty. Boston Fed President Susan Collins hinted that the Fed might consider cutting interest rates soon if inflation continues to decline. Despite recent weaker job numbers, Collins emphasized that the labor market remains robust, a crucial factor for achieving the Fed's 2% inflation target. She clarified that any decisions on rate cuts would depend on upcoming data, particularly as the September Fed meeting approaches. Richmond Fed President Tom Barkin echoed Collins's cautious optimism, noting that the U.S. economy has time to return to normal. He pointed out that cooling inflation supports a measured approach to adjusting rates and suggested that the Fed could afford to wait for more data before making significant policy changes. These statements have quickly shifted market expectations, with investors now increasingly betting on multiple rate cuts by the end of the year. The probability of a 50 basis points cut in September has surged past 50%, with up to four cuts anticipated by December. The turbulence in Japan likely accelerated this shift, as investors seek safety amid growing uncertainty. Meanwhile, the European Central Bank (ECB) maintained a composed stance despite the global market jitters. ECB Governing Council member Olli Rehn dismissed the market’s reaction as an "overreaction," attributing it to thin trading during the holiday season rather than economic fundamentals. The ECB continues to focus on maintaining price stability and supporting growth, with a modest 25 basis points rate cut expected in September.
Last week ended relatively well for the corporate bond market, with some spread tightening observed across the credit spectrum. In the U.S., investment-grade corporate bonds saw average spreads tighten by 3 basis points, closing at 102 bps. However, this is still wider than levels seen at the start of August, when spreads were at 93 bps. The high-yield sector experienced more significant movement, with average spreads narrowing by 20 bps to 339 bps, reflecting a normalization after the sharp spike in spreads due to recent market volatility. Notably, the volatility in U.S. credit markets hit its highest level since October 2023 before retracing about halfway. Despite this volatility, corporate bonds performed relatively better than government bonds. The Vanguard USD Corporate Bond ETF posted a modest decline of 0.46%, which was half the loss seen in U.S. Treasuries. In contrast, the iShares Broad USD High Yield Corporate Bond ETF managed a slight gain of 0.2% for the week, though it remains down by 0.3% month-to-date. In Europe, the picture was slightly different, with investment-grade credit spreads widening by 2 bps to 120 bps, while high-yield spreads remained flat at 389 bps. Thanks to only modest negative contributions from European rates, both ETFs tracking European corporate bonds managed to post positive performances over the week. The iShares Core Euro IG Corporate Bond ETF gained 0.1%, while the iShares Euro HY Corporate Bond ETF rose by 0.3%. An interesting development in both the U.S. and European markets is the evolution of yields. For the first time in 2024, the average yield to maturity of investment-grade corporate bonds fell below 5% in the U.S. and below 3.5% in Europe. In the high-yield segment, the widening of credit spreads offset the drop in interest rates, preventing a significant decline in yields to maturity. European subordinated debt also saw a decent rebound last week, with the WisdomTree AT1 CoCo Bond ETF and the Invesco Euro Corporate Hybrid ETF rising by 0.5% and 0.4%, respectively. These indexes have remained relatively stable since the start of August, contrasting with the -4% decline in European equities. Impressively, these subordinated debt indexes are up nearly 6% year-to-date, almost in line with European stock market performance!
The government bond market experienced a challenging week, failing to capitalize on the volatility in equities. Despite the typical negative correlation between bonds and equities, most of the yield movement, particularly the decline, had already occurred the previous week following the Federal Reserve's meeting and a disappointing U.S. jobs report. This left little room for further downward pressure on yields as the market processed new developments. The Bank of Japan’s reassuring comments helped stabilize global markets, but a poorly received U.S. bond auction on Wednesday added pressure to yields. Investors shunned a $42 billion auction of benchmark 10-year U.S. Treasury securities, which resulted in a yield significantly above the pre-sale indicative level. This reaction pushed yields higher, with the 10-year U.S. Treasury yield rising by 15 basis points over the week, closing just under 4% at 3.94%. Similarly, the 2-year U.S. Treasury yield increased by 17 basis points, closing the week at 4.05%. The U.S. yield curve, measured by the difference between 2-year and 10-year Treasury yields, briefly flirted with zero for the first time since July 2022 but ended the week at -11 basis points, maintaining its inverted stance. This inversion reflects ongoing concerns about future economic growth. The MOVE index, which tracks U.S. interest rate volatility, spiked above 120 during the week—a level only reached twice in 2024—before settling back to 108, indicating that a high volatility regime persists in the rates market. In this context, the iShares USD Treasuries ETF lost 0.9% over the week, though it remains up by 0.7% since the start of August. In Europe, rate movements were less pronounced, with the 10-year German Bund yield rising modestly by 5 basis points to 2.22%. Unlike U.S. Treasury yields, which are close to levels seen at the start of the year, German yields remain elevated. The volatility in markets had minimal impact on peripheral European rates, with the spread between 10-year German and Italian yields tightening by 4 basis points to 141 basis points. Consequently, losses in European government bonds were more contained, with the iShares Core EUR Govt bond ETF down by just 0.1%. Similarly, UK and Swiss bonds followed the broader trend, each losing about 0.4% over the week.
Emerging market
Emerging markets experienced a volatile week, but it ended on a positive note as spreads tightened across key segments. The Bloomberg EM Corporate Bond Index saw its spreads narrow by 7 basis points to 230 bps, although this level remains the highest since mid-April. Similarly, EM sovereign bond spreads tightened by 13 bps to 348 bps, contributing to a positive excess return. However, this tightening was insufficient to offset the negative impact of rising U.S. interest rates. As a result, the iShares Emerging Market Corporate Bonds ETF fell by 0.4% over the week, while the iShares Emerging Market Sovereign Bonds ETF declined by 0.2%. These losses were further exacerbated by the largest weekly outflows from EM ETFs in ten months. In contrast, the VanEck J.P. Morgan EM Local Currency Bond ETF posted a strong 0.7% gain for the week, driven by robust performance in local currency bonds, particularly in Mexico. Mexican bonds benefitted from the central bank, Banxico, cutting its key rate by 25 basis points to 10.75%, as expected. Governor Victoria Rodriguez hinted at further rate reductions, citing slowing growth and a consistent decline in inflation over the past 18 months. This led to a significant drop in the 10-year local Mexican yield to 9.4%, its lowest level since early April. In China, local currency government bond yields continued to decline, with the 30-year government yield hitting an all-time low of 2.3%. This reflects ongoing concerns about the strength of the Chinese economy, as investors seek safety in long-duration bonds amidst a challenging economic environment. The International Monetary Fund (IMF) approved two significant deals. Pakistan secured a $7 billion package to help manage its looming $24 billion in loan repayments due over the next 12 months. This development has bolstered market confidence, with Pakistan bonds up 28% year-to-date, and Fitch recently upgraded the country’s rating from CCC to CCC+. In El Salvador, after three years of negotiations, the IMF announced preliminary agreements for a new financing program, providing much-needed financial stability to the country. Finally, in Africa, Uganda’s central bank made a noteworthy move by cutting interest rates for the first time in a year, following a revision of its inflation forecasts. This decision reflects broader trends in emerging markets where central banks are increasingly leaning towards easing monetary policy to support growth amid global uncertainties.
