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What happened last week?
The central banks are closing the year with contrasting approaches, reflecting the diverse challenges they face. Last week, the European Central Bank (ECB) and the Swiss National Bank (SNB) both delivered rate cuts, but the size and messaging behind these decisions highlighted significant differences. In the Eurozone, the ECB reduced its key rate by 25 basis points as expected, maintaining a cautious stance. Despite ongoing economic weakness, “core” inflation remains above the ECB’s 2% target, and wage growth unexpectedly accelerated in Q3. President Lagarde emphasized the need for prudence, signaling that monetary conditions will remain restrictive for now. The ECB’s careful communication underscores its balancing act: managing persistent inflationary pressures without overstimulating a fragile economy. In contrast, the Swiss National Bank took a bolder step, surprising markets with a 50bp rate cut. Chairman Martin Schlegel justified the decision as a necessary response to low and slowing inflation, combined with upward pressure on the Swiss franc. The cut aims to support domestic demand and counteract negative external factors, with Schlegel hinting at further easing in 2025. The juxtaposition between the ECB and SNB reflects their differing struggles—one grappling with stubborn inflation despite weak growth, the other contending with a strong currency and deflationary risks. The Federal Reserve now takes center stage with its final meeting of the year. Markets are pricing a 97% probability of a 25bp rate cut, making a third consecutive reduction highly likely after the September and November moves. The Fed has historically aligned with market expectations when confidence levels are this high. However, the spotlight will be on the updated economic projections and the “dot plot” for 2025. With U.S. GDP growth projected at +3.3% annualized in Q4 and inflation stabilizing slightly above target, the Fed’s outlook could shift significantly. Expected revisions to growth, inflation, and rate forecasts may reflect the anticipated impact of expansionary Trumponomics, adding complexity to the policy path ahead. The Bank of England will also conclude its year, likely opting to pause its rate cut cycle as it waits for confirmation of November inflation data. While recent growth indicators have been soft, the unexpected October inflation uptick calls for caution. Across the globe, the Bank of Japan faces its own decision. With inflation surprising on the upside, futures markets assign a 17% probability of a rate hike, leaving investors uncertain if the BoJ will deliver a third hike before year-end. As 2024 concludes, central banks navigate unique challenges, setting the stage for potentially divergent monetary paths in the year ahead.
U.S. Treasuries experienced a challenging week, driven by renewed inflation concerns that reignited selling pressure across the curve. The iShares 3-7 Year Treasury Bond ETF declined -0.84%, while the iShares 10-20 Year Treasury Bond ETF plunged -3.4%, marking one of its worst weekly performances of the year and dragging its year-to-date return back into negative territory at -2.3%. A notable shift occurred in the U.S. yield curve (3m10s), which turned positive for the first time in over two years. This development reflects evolving market expectations ahead of an anticipated rate cut by the Federal Reserve this week. Despite the backdrop of a disappointing Initial Jobless Claims report, the 10-year U.S. Treasury yield surged from 4.15% to 4.40%, underscoring persistent concerns over inflation and fiscal imbalances. Two key factors continue to weigh on Treasuries: rising inflation expectations and the ballooning U.S. budget deficit. Together, they contribute to elevated term premiums, which increase the yield required by investors to hold longer-duration bonds. Compounding the pressure is a diminished appetite from foreign investors, traditionally significant buyers of U.S. Treasuries. However, the MOVE index, a measure of interest rate volatility, dropped to 85, its lowest level this year. This decline signals reduced volatility expectations, offering a glimmer of stability amidst broader market turbulence. In Europe, bond markets mirrored the struggles seen in the U.S., despite another rate cut by the European Central Bank. The iShares Core EUR Govt Bond ETF fell -1% last week, although it remains up +2.4% for the year. European yields rose in tandem with U.S. rates, but inflation concerns appear less pronounced than across the Atlantic. Instead, growing supply concerns for 2025 loom as a potential headwind for European government bonds. Unless the ECB pauses or reverses its quantitative tightening program to reintroduce bond purchases, supply pressures could exacerbate market challenges in the coming year. One striking development was the inversion of the spread between the 10-year German Bund yield and the 10-year EUR swap rate, which turned negative for the first time in history. This tightening reflects expectations of higher public borrowing by Germany, a factor set to increase Bund issuance in 2025. As the supply of Bunds grows, their perceived safety premium diminishes, narrowing the spread with EUR swaps. Looking ahead, the interplay between inflation fears, fiscal dynamics, and central bank actions will remain critical in shaping global rate movements, with investors closely monitoring developments in both the U.S. and Europe. As central banks take center stage this week, the bond market's reaction to rate decisions and forward guidance will provide crucial signals for the months ahead.
Emerging market
Emerging market (EM) bonds experienced mixed performance last week as the iShares Emerging Market Sovereign Bonds ETF dropped -1.6%, despite EM sovereign spreads narrowing to 248 basis points—their lowest level since 2018. Similarly, the iShares Emerging Market Corporate Bonds ETF slipped -0.6%, even as EM corporate spreads tightened by 10 basis points to 202 bps, reflecting resilient investor demand for corporate debt. These movements highlight the divergent forces at play in EM fixed income markets, with tightening spreads failing to offset broader market pressures. In Brazil, the central bank took a more aggressive monetary policy stance, raising the SELIC rate by 100 basis points to 12.25%, double the previous 50 bp hike. The Banco Central do Brasil signaled matching 100 bp increases in its next two meetings, aiming to combat persistently high inflation and anchor expectations. This hawkish pivot underscores the challenges facing Latin American economies as they navigate inflationary pressures while trying to maintain economic growth. China captured market attention following the December 9th Politburo meeting chaired by President Xi Jinping. The meeting reaffirmed a robust pro-growth stance for 2025, with a stronger commitment to economic expansion than had been conveyed in September. Despite these assurances, Chinese bond yields continued to plummet, reflecting a banking system flush with liquidity and a market expecting muted growth and inflation. The benchmark 10-year yield has fallen over 80 basis points this year to a record low of 1.78%, while the yield discount on Chinese bonds versus U.S. Treasuries reached its widest in 22 years. This dynamic has fueled a rally in Asian high-yield debt, with the iShares USD Asia High Yield Bond ETF rising +0.9% last week, marking a bright spot in the broader EM credit landscape. In South Africa, inflation surprised significantly to the downside, falling to 2.9% year-on-year, well below the South African Reserve Bank’s target range. This creates ample room for potential rate cuts, providing a supportive backdrop for South African bonds. The prospect of monetary easing has bolstered investor sentiment, as the country benefits from improved inflation dynamics relative to other emerging markets. Overall, while EM spreads are tightening and select segments, such as Asian high yield, are performing well, the broader market faces headwinds from global rate pressures and uneven regional dynamics. Investors will need to navigate these complexities carefully, as the divergence between sovereign and corporate bonds highlights opportunities for selective positioning within the asset class.
