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What happened last week?
Last week, the European Central Bank (ECB) made headlines by cutting its key interest rates by 25 bps, marking its second rate cut this year. Despite these reductions, the ECB’s stance remains restrictive as interest rates are still higher than inflation, keeping monetary policy tight. The ECB is proceeding cautiously, aiming to address persistent inflationary pressures, particularly from rising wages. Economic projections now forecast slower growth for 2024, and inflation is expected to return to the 2% target by 2026. Another rate cut in December appears likely, although there is uncertainty surrounding the possibility of an additional cut as early as October. Currently, the market is split, with a 50% probability of a rate cut next month. This week promises to be busy for developed market (DM) central banks, with key decisions from the Federal Reserve, the Bank of Japan, and the Bank of England. In the U.S., the market is highly divided, assigning a 50/50 chance to a 25 bps or 50 bps rate cut. The Fed's decision will also be accompanied by the release of the "dot plot" forecast, which could reveal a divergence between the market's expectations and the Fed's outlook. Market participants are keen to see how risk assets will react to either scenario. Anyway, the current cycle has marked the longest the Fed has held rates at its peak before cutting. In the U.K., despite soft economic data and already restrictive monetary policy, the Bank of England is widely expected to keep interest rates unchanged, with only a 25% chance of a rate cut priced in by the market. Meanwhile, the Bank of Japan is expected to hold rates steady but could open the door to a potential 10 bps hike in its October meeting, with the market assigning an 80% likelihood of such a move.
Last week’s rally in U.S. equities, the strongest of 2024, did little to lift U.S. credit spreads. Both Investment Grade (IG) and High Yield (HY) spreads remained flat at 97 bps and 322 bps, respectively. Credit performance was entirely driven by falling rates. The Vanguard USD Corporate Bond ETF gained 0.4%, while the iShares Broad USD High Yield Corporate Bond ETF posted a +0.6% return. Interestingly, history shows that IG bonds have consistently delivered strong returns in the 12 months following the first Fed rate cut, with an average gain of 10% across the last nine easing cycles since 1980. In company news, Boeing faced another setback on Friday as Moody's placed its Baa3-rated bonds on review for a potential downgrade due to concerns about the impact of a machinist strike on cash flow. Should Boeing fall into speculative-grade or "junk" status, the $45 billion in debt on its balance sheet would face higher borrowing costs and could be excluded from investment-grade portfolios, including pension funds that are restricted to holding only IG debt. In Europe, the iShares Core Euro IG Corporate Bond ETF rose by 0.2%, despite a slight widening of spreads to 121 bps (+3 bps). European high yield also remained steady, with spreads unchanged at 380 bps. The iShares Euro HY Corporate Bond ETF gained +0.3%, supported by falling peripheral rates. Meanwhile, in the AT1 space, a significant development occurred in Australia, where regulators proposed phasing out AT1 bonds in favor of Tier 2 bonds and common equity. The Australian Prudential Regulation Authority (APRA) aims to simplify the system and reduce risk, particularly for retail investors, with the transition set to begin in January 2027 over a five-year period. This move had little impact on European AT1 bonds, with the WisdomTree AT1 CoCo Bond ETF rising +0.5% last week, outperforming the Invesco Euro Corporate Hybrid ETF, which gained +0.3%.
U.S. government bond yields ended the week lower, with declines ranging between 5 to 10 bps across the curve. The bull steepening trend continued, pushing the 2s10s yield curve to a new cycle high. The difference between 2- and 10-year Treasury yields reached 8 bps last week, largely driven by expectations of aggressive Fed easing in the near future. Meanwhile, the 30-year U.S. Treasury yield dropped below 4% for the first time in 2024, a positive development for long-duration assets. Adding to this favorable environment, the U.S. Treasury successfully auctioned $39 billion in 10-year bonds, with strong demand—76% from indirect bidders, the highest level since February 2023. The iShares USD Treasuries ETF gained 0.5% last week, bringing its year-to-date performance to +4.6%. TIPS (Treasury Inflation-Protected Securities) also posted solid gains, with the iShares USD TIPS ETF up 0.9% for the week and +4.8% year-to-date. The 5-year U.S. breakeven rate, which reflects the market’s inflation expectations, increased by 8 bps to 1.96%, supported by a 1.5% rebound in oil prices. In Europe, government bond yields declined as well, though to a lesser extent than in the U.S. The 10-year German yield fell by 2 bps to 2.15%, while the 10-year French yield dropped by 4 bps to 2.84%. Peripheral bonds outperformed, with Spanish yields falling by 6 bps across the curve, bringing the 10-year yield below 3% for the first time this year. Italian bonds saw a particularly strong week, helped by robust demand for a 30-year bond auction, which attracted a record EUR 130 billion in bids. As a result, the spread between 10-year Italian and German yields tightened to 136 bps from 145 bps a week earlier. The iShares Core EUR Govt Bond ETF rose by 0.3% for the week, now up 1.7% year-to-date. In the U.K., bond yields fell sharply by over 10 bps, with the 10-year yield ending the week at 3.76%. This move was driven by weaker-than-expected economic data, including lower wage growth and disappointing industrial production figures.
Emerging market
Emerging market (EM) bonds capitalized on the rally in U.S. Treasuries last week, with EM sovereign bonds leading the charge. The iShares Emerging Market Sovereign Bonds ETF climbed +1.2%, helped by a 5 bps tightening in spreads. Meanwhile, EM corporates faced some pressure, with spreads widening by 6 bps to 242 bps, but still posted solid performance, with the iShares Emerging Market Corporate Bonds ETF gaining +0.7%. The VanEck J.P. Morgan EM Local Currency Bond ETF also performed well, rising +1.0%. Notably, EM high-yield bonds have delivered an impressive 11% return so far in 2024, marking their best year-to-date performance since 2016. On the ratings front, Fitch affirmed South Africa's long-term issuer default rating at BB-, while raising the Republic of Turkiye’s rating to BB- from B+, signaling positive momentum in both countries’ credit outlooks. However, in China, recent economic data for August reflected broad-based weakness, casting doubts on the country’s ability to meet its 5% growth target for 2024. This uncertainty pushed China’s 10-year and 30-year government bond yields to record lows last week, at 2.01% and 2.15%, respectively—an unprecedented drop that now places China’s ultra-long yields below those of Japan for the first time. In response, the People's Bank of China (PBOC) announced plans to introduce additional policies aimed at lowering corporate and household financing costs. On the performance side, the iShares USD Asia High Yield Bond ETF lagged behind, remaining flat over the week, reflecting broader challenges within the Chinese real estate sector. Finally, next week brings a series of central bank decisions from key EM countries, including Turkey, South Africa, Indonesia, and Brazil, which could provide further direction for the EM bond market.
