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What happened last week?
This week brought a subtle yet notable shift in expectations regarding central bank policies, particularly in the U.S., where confidence in a significant rate cut has waned. The probability of a 50 basis points cut at the upcoming Federal Reserve meeting has dropped from nearly 60% to just over 25%, reflecting a more cautious tone from both the markets and Fed officials amid mixed economic signals. Chicago Fed President Goolsbee flagged rising unemployment and increased credit card delinquencies as signs of potential economic trouble. While these indicators are concerning, Goolsbee refrained from pushing for an immediate rate cut, highlighting the complexities of the current economic landscape. In contrast, St. Louis Fed President Musalem conveyed a more balanced outlook, suggesting that inflation is moving closer to the Fed’s 2% target and that the labor market is stabilizing. This progress might justify a rate cut soon, although Musalem remains cautious about acting too quickly. Atlanta Fed President Bostic emphasized the importance of additional data before making a move. While recent inflation trends are promising, Bostic warned against premature action that could lead to a rapid reversal, leaving open the possibility of a rate cut later in the year if conditions permit. Across the Atlantic, the European Central Bank (ECB) had a quiet week, with markets still almost fully expecting a rate cut in September. In the UK, signs point to another potential rate cut due to slowing wage growth and cooling inflation, but market sentiment remains skeptical, with only a 35% chance priced in. In Japan, the political landscape is influencing monetary policy expectations, as candidates for the upcoming prime ministerial role debate the direction of interest rates. Despite these discussions, the market does not anticipate any changes from the Bank of Japan at its mid-September meeting. Overall, while further easing measures are likely in September, the aggressive rate cuts currently priced into the U.S. market might be overly optimistic as central banks continue to navigate complex economic conditions.
The recent widening of credit spreads following the sharp selloff in Japanese equities now seems a distant memory. The iTraxx Xover index, which tracks the most liquid CDS in European high yield, has already dipped back below 300 bps, while the U.S. equivalent, the CDX HY index, dropped by 30 bps to 333 bps, fully recovering to pre-crisis levels. As a result, high yield was the top performer this week, with HY ETFs reaching their highest levels of 2024. The iShares Broad USD High Yield Corporate Bond ETF is now up 5.9% year-to-date, gaining 0.9% this week, while the iShares EUR High Yield Corp Bond ETF has risen 2.9% this year, including a 0.6% gain this week. Adding to the positive momentum, Warner Music was upgraded to investment grade by S&P, a move that reflects strong growth fundamentals in the global music industry and WMG’s solid positioning within this space. Beyond high yield, other high beta credit indices also performed well. The WisdomTree AT1 CoCo Bond ETF, which tracks subordinated bank debt, gained 0.7% over the week, while the Invesco Euro Corporate Hybrid ETF rose 0.5%. Both of these riskier debt categories have gained more than 6% in EUR terms so far in 2024. Investment grade credit also delivered solid returns, with the Vanguard USD Corporate Bond ETF up 0.7% for the week and the iShares Core Euro IG Corporate Bond ETF up 0.1%. Interestingly, JPM noted that the BBB/A spread ratio is at a record low of just 1.2x, even lower than during the ECB’s CSPP/PEPP programs in 2021. This suggests that there is limited room for further tightening in the lower quality segment of investment grade credit. As the macroeconomic outlook evolves, any deterioration could disproportionately affect BBB-rated bonds, which are more vulnerable compared to their A-rated counterparts. Overall, while credit markets have shown resilience, the potential for further spread tightening, especially among lower-quality investment grade bonds, may be reaching its limits.
This week, the U.S. yield curve continued its flattening trend, with the 2s10s spread deepening by nearly 10 basis points to end at -20 bps. Long-term bonds outperformed, as the 10-year U.S. Treasury yield dipped to 3.9%, down 4 bps from last week, while the 2-year yield, more sensitive to Fed policy speculation, rose by 5 bps. This divergence reflects growing skepticism around a large rate cut in September and a focus on improving inflation data. As a result, the long end of the curve saw the iShares 10-20 Year Treasury Bond ETF gain over 0.5%, while the intermediate segment remained flat. This flattening dynamic was echoed across other developed markets. In Europe, the iShares EUR GOVT 3-7Y ETF saw a slight dip, while the iShares EUR GOVT 10-15YR ETF climbed 0.4% for the week. The German yield curve ticked up slightly, with the 10-year Bund closing at 2.25% (from 2.23% the week prior). Meanwhile, tightening spreads in peripheral bonds, especially between Italian and German yields, provided a positive boost, with Italian real yields dropping to their lowest since 2022. In the UK, despite a mix of economic signals—rising jobless claims to their highest level since 2009 and softer-than-expected inflation—markets remained subdued. The BB Series-E UK Govt 1-10 Yr Bond was flat, while the Vanguard U.K. Gilt UCITS ETF inched up by 0.3%. Over in Japan, government bond yields rose across the curve, with the 2-year yield jumping 7 bps to 0.36%, and the 10-year yield increasing by 3 bps to 0.88%, reflecting ongoing adjustments amid a shifting global landscape. Overall, the persistent flattening of yield curves across major markets highlights the difficulty of reversing the trend back to positive territory. The next round of easing measures could be pivotal in determining whether this shift will gain momentum.
Emerging market
It was an outstanding week for emerging market debt, as spreads narrowed to near their lowest levels of the year, and EM currencies gained nearly 0.5%. Leading the charge was the South African rand, which extended its longest winning streak in 13 years. The standout performer in the bond space was EM sovereign debt, with the iShares Emerging Market Sovereign Bonds ETF gaining 1.1% over the week. This rally was bolstered by strong demand from foreign investors, who were net buyers of Asian bonds for the third consecutive month in July. Indian bonds, in particular, saw a surge in interest, with a net investment of $2.68 billion—the highest in five months—following their inclusion in JP Morgan's Emerging Market Debt Index in June. This inclusion is expected to bring monthly inflows of around $2 billion, boosting Indian bonds' weight in the index to approximately 10% by March 2025. EM local debt also had a strong showing, with the VanEck J.P. Morgan EM Local Currency Bond ETF up 1.2%, supported by a broad recovery in EM currencies against the U.S. dollar. EM corporate bonds posted a solid 0.7% gain, while Asian high yield bonds recovered well, rising 1% over the week. Impressively, this segment of the fixed income market is up more than 11% year-to-date, a remarkable feat given the ongoing struggles in China's real estate sector. For instance, Chinese home prices recently recorded their largest decline in history, and Moody's downgraded major developer Vanke to B1. Among the best performers in Asian high yield were Pakistani bonds, which account for nearly 5% of this segment and have surged over 30% year-to-date. This rally was driven by the IMF’s $7 billion package aimed at helping Pakistan manage its $24 billion in loan repayments due over the next 12 months. Finally, the Reserve Bank of New Zealand (RBNZ) added to the global easing trend, cutting its key rate by 25 bps to 5.25%, citing a rapid deterioration in economic activity.
