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What happened last week?
This week, central banks kept things relatively calm, but there were still important signals to catch. In the U.S., the Fed’s favorite inflation gauge stayed flat at 2.5% in July. Atlanta Fed President Raphael Bostic pointed out that inflation is still "far" from the Fed’s 2% target, signaling that there’s no rush to cut rates just yet. He’s comfortable with a terminal rate of around 3%, which lines up with market expectations, aiming for that level by January 2026. Meanwhile, over in San Francisco, Fed President Mary Daly echoed the idea of starting rate cuts soon but stressed that the Fed will move cautiously. Daly’s stance is that while the Fed is ready to ease up, they’re keen to avoid any sudden shocks to the labor market. The market, however, is already gearing up for action, pricing in four rate cuts by year-end, with a total of 200 basis points expected to be trimmed over the next 12 months. Across the Atlantic, the European Central Bank (ECB) is weighing its options. ECB Governing Council member François Villeroy de Galhau sees a September rate cut as "fair and wise," given the slowdown in inflation. Yet, ECB Executive Board member Isabel Schnabel remains cautious, noting that services inflation is still a concern. The market is currently betting on two to three rate cuts from the ECB by year-end, aiming for a terminal rate of around 2%. In Japan, inflation in Tokyo picked up, with consumer prices excluding fresh food rising by 2.4% in August, higher than expected. Bank of Japan Deputy Governor Ryozo Himino didn’t rule out further rate hikes but emphasized that the BOJ will proceed carefully, keeping an eye on financial market stability. While the BOJ is likely to hold rates steady in September, they’ve made it clear that another rate hike could be on the horizon if economic conditions support it.
August was a strong month for USD credit, driven by favorable interest rate movements. U.S. corporate bond spreads remained steady at 93 bps, while the Vanguard USD Corporate Bond ETF gained over 2% for the month, bringing its year-to-date return to +4%. This performance was largely due to the carry from credit spreads and declining interest rates, with credit spreads tightening by just 3 bps year to date. Notably, credit market volatility has been rising since May. The USD high-yield market also performed well, with spreads tightening by 9 bps to 305 bps. The USD High Yield Corporate Bond ETF gained +1.6% in August, contributing to a year-to-date return of +6.8%. In Europe, investment-grade corporate spreads widened by 7 bps to 117 bps, resulting in negative excess returns. However, the iShares Core EUR Corp Bond ETF still managed a +0.2% gain in August, with a +2.2% return year to date. European high-yield outperformed, with spreads tightening by 17 bps to 360 bps. The iShares EUR High Yield Corp Bond ETF rose nearly +1% for the month, achieving a +3.4% year-to-date return. Subordinated debt also saw gains, with the Invesco Euro Corporate Hybrid ETF up +1.5% and the WisdomTree AT1 CoCo Bond ETF up +1.2%. Both segments are now up +7% year to date, reflecting strong demand. Goldman Sachs reports that net leverage for the median investment-grade issuer remains stable at 2.7x, near its historical high, while high-yield leverage is steady at 3.4x, at the lower end of its range. Interest coverage ratios for investment-grade issuers have declined for the 10th consecutive quarter to 5.5x, slightly below the long-term average. In the European high-yield market, CCC-rated bonds now make up over 7% of the index, up from 2% in 2018. Despite this, the EUR HY market maintains a quality edge over its USD counterpart, with 66% of the EUR HY market being BB-rated versus 51% in the USD market. Additionally, 74% of B-rated bonds in the EUR market are secured, compared to 47% in the USD market, reflecting a higher entry barrier for EUR HY issuers.
U.S. Treasury bonds have seen a 3% gain year-to-date, primarily driven by a rally of over 6% since late April. However, this rebound is somewhat deceptive. Despite these gains, the 10-year U.S. Treasury yield ended August at 3.9%, the same level it closed at in 2023. This indicates that 2024’s positive performance has been largely due to carry, rather than a significant rally in yields. The iShares 3-7 Year Treasury Bond ETF rose by 1.2% in August, and the iShares 10-20 Year Treasury Bond ETF gained 1.8%, bringing their year-to-date performances to +3.2% and +1.6%, respectively, supported by a steepening yield curve. The U.S. yield curve (2s10s) is nearing positive territory, ending August at -1.9 bps, the closest to positivity since June 2022. U.S. inflation-linked bonds underperformed in August as the 10-year U.S. breakeven rate dropped to 2.15% from 2.23% in July, and the 10-year U.S. real yield fell by 5 bps to 1.75%. Despite this, the iShares USD TIPS ETF gained 0.8% in August and is up 3.3% year-to-date, continuing to lead within the Treasury segment. In Europe, government bond performance was more subdued. The iShares EUR Govt 3-7Y ETF rose by 0.4%, while the iShares EUR Govt 10-15Y ETF was flat in August. Year-to-date, German rates have climbed nearly 25 bps for the 5-year yield, with the U.S.-Euro 5-year yield spread dropping below 150 bps for the first time in a year. Despite a drop in French inflation to its lowest level in three years, the French yield curve has risen almost 50 bps year-to-date, with the 10-year French nominal yield above 3% and the 10-year French real yield at its highest since 2012 at 1.20%. Italy stood out as the best performer in European government bonds, with the 10-year Italian yield holding steady at 3.7%, the same level it started the year. In the UK, the 10-year yield edged back above 4% in August, now up 50 bps in 2024. The market remains hawkish on UK government yields, with less than two rate cuts expected by year-end and four within the next year. The iShares Core UK Gilts ETF remains in negative territory year-to-date at -0.5% and has lost 23% over the last five years. Finally, in Japan, after six consecutive months of rising yields, the 2-year yield ended August lower at 0.36%, down from 0.40% in July. Notably, last week’s Japan 2-year bond sale drew the highest demand ratio since 2019. The 10-year Japanese yield fell by 15 bps to 0.89%, helping the iShares Core JP Government Bond ETF gain 1.8% in August.
Emerging market
August ended on a strong note for Emerging Market (EM) bonds, particularly for EM local currency debt, which posted an impressive 3% gain—the best performance among fixed income segments in USD terms. This surge was largely driven by strengthening Asian currencies against the U.S. dollar. On the other hand, despite solid local debt performance, both Mexico and Brazil faced headwinds due to sharp sell-offs in their currencies. In USD denominated debts, the iShares Emerging Market Corporate Bonds ETF closed the month up 1.8%, while the iShares Emerging Market Sovereign Bonds ETF gained 2.3%. However, it wasn’t all smooth sailing for EM corporate bonds. The spread on EM corporate bonds widened by 2 bps over the month, ending at 218 bps. This marks the third consecutive month of slight widening, up from 208 bps at the end of May. In contrast, EM sovereign spreads tightened by 16 bps in August to 322 bps, though this still reflects only modest improvement from the 316 bps seen at the end of May. The Asian high-yield segment continued its strong performance in 2024, with the iShares USD Asia High Yield Bond ETF adding 1% in August, bringing its year-to-date return to 12.4%. Despite a 10% decline over the past five years, this segment shows promise of continued recovery. China’s potential plan to allow homeowners to refinance up to $5.4 trillion in mortgages could further support this recovery, as it aims to reduce borrowing costs, stimulate consumer spending, and address the ongoing challenges in the property market. However, risks remain, as evidenced by Moody’s recent downgrade of Longfor Group, one of the few developers still meeting its obligations, from Ba2 to Ba3. In Europe, Bulgaria made headlines with its largest foreign debt sale ever, totaling nearly $5 billion. With a positive outlook from S&P, Bulgaria is seen as having a "one-in-three likelihood" of joining the eurozone within the next 24 months. The country’s economic fundamentals are strong, with inflation at 2.4% in July, a fiscal deficit expected to remain below 3% through 2027, and debt-to-GDP projected to stay under 30%. However, political instability remains a concern as Bulgaria heads into its seventh election in just three and a half years, struggling to form a stable majority government. Meanwhile, in Brazil, the energy sector received a boost with Electrobras being upgraded to BB by S&P. In Mexico, significant political changes are on the horizon, as President-elect Claudia Sheinbaum appointed Victor Rodriguez Padilla as the new CEO of Pemex, signaling potential shifts ahead for the state-owned oil giant.
