Bonds in brief: making sense of the macro - February issue

Marco Giordano, Investment Director
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Welcome to February’s “Bonds in brief”, our monthly assessment of risks and opportunities within bond markets. 

Key points:

  • Global yields continued to rise after stronger-than-expected economic data pushed out the expected timing of rate cuts by the US Federal Reserve (Fed) and other central banks. Resilient consumer spending and strong corporate earnings helped propel further spread tightening across most fixed income sectors. By the end of February, markets had taken out three of the Fed cuts previously priced in, and now expect the Fed to start reducing policy rates in June at the earliest.
  • While it’s clear that inflation has now peaked, central banks are looking for reasonable assurance that inflation is trending towards 2%. So far, economic indicators have remained resilient across most of the developed world, telling investors that we’re not yet seeing significant slack generated in the global economy.
  • Following the pattern of slowing (but positive) US growth and upside surprises in Europe, credit markets saw continued spread tightening in February, supported by strong earnings and an improving macro picture. To put this in context, global investment-grade spreads are now back at the levels seen at the end of 2021, before the hiking cycle began; however, all-in yields remain at levels last seen in 2009, meaning record issuance by companies could be met by growing allocations to credit funds.

What are we watching? 

  • Global tensions. The ongoing dangerous situation in Ukraine continues to be monitored by our geopolitical strategists. Ukrainian troops were forced to retreat from the town of Avdiivka, losing a city for the first time in nearly a year. The disruption to global shipping in the Red Sea continued with the sinking by Houthis of the British-owned ship Rubymar, which was carrying a cargo of fertiliser. In addition to the potential environmental damage, we continue to observe upward pressure on freight shipping insurance and near-term pressure on freight rates.
  • Who does the European Central Bank set rates for? One of the biggest challenges for the ECB, and consequently for European investors, is to set policy for multiple countries. The return of the growth/inflation trade-off makes the ECB’s task exceptionally difficult, as economic data continues to diverge across countries. In this context, Germany’s economic underperformance really stands out relative to the rest of the euro area, and particularly so against the periphery countries. The central bank’s long-standing policy of setting rates for the average means rates are likely to be restrictive for Germany just when it needs loosening. This is a reversal of fortunes from the early 2010s, when the opposite was true, and Germany imposed strict fiscal discipline on southern Europe. 
  • Bond market liquidity has been increasingly at the forefront of investors’ and regulators’ minds in the wake of heightened volatility, quantitative tightening programmes and the risk of exogenous shocks (such as the gilt crisis in 2022) causing liquidity to dry up. The International Capital Market Association recently published1 an analysis of the top five European sovereign debt markets, finding that while liquidity is generally good, “market participants accept that episodic heightened volatility, with rapid evaporation of liquidity, and a sharp repricing of risk, is the new normal”. This is another reminder that investors need to adapt to a new market regime.

Where are the opportunities? 

  • Given how drawn out and uncertain the rate cycle has been this year, we continue to see opportunities in higher-quality total return strategies that are less constrained by benchmarks. This could include global sovereign and currency strategies or unconstrained strategies that are able to navigate the late cycle by allocating across different sectors.
  • In our view, core fixed income, and particularly credit, strategies are looking increasingly attractive. Higher-quality fixed income is attractive from both an income and capital protection perspective, with the income from these strategies not only attractive outright but also providing an additional buffer to rate volatility. 
  • We think high-yield and emerging markets debt still offer potential, but we expect continued volatility along with geopolitical risk. High-yield fundamentals may worsen as lagged policy effects work their way through the economy, but corporate earnings have remained resilient so far. Notably, in Europe, we have not seen the same leverage buildup in the high-yield market as we saw in previous cycles.

1 Liquidity and resilience in the core European sovereign bond markets, International Capital Market Association, March 2024.

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