Bonds in brief

The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

Welcome to July’s edition of Bonds in Brief, our monthly assessment of risks and opportunities within bond markets for fixed income investors. Each month, we explore material macro changes and how best to navigate the latest risks and opportunities we see within bond markets.

Key points

Government bond yields generally rose in July amid tariff uncertainty, ongoing concerns about fiscal sustainability and stronger-than-expected economic data. Credit spreads tightened, driven by government bond yields edging higher. Attractive all-in yields and the presence of yield-motivated buyers in the market continue to provide strong technical support, and a seasonal reduction in corporate bond supply could also act as catalyst for spreads to grind tighter.
US economic data puzzled policymakers and markets due to the lack of a clear trend, with signs of positive growth combined with incoming fiscal stimulus balanced out by declining exports and some cracks appearing in labour markets. Meanwhile, in Europe, economic data surprised to the upside on relatively downbeat expectations, reflected in higher bond yields across European markets.
Trade discussions between the US and China, Mexico and Canada remained ongoing, but the EU and Japan reached a trade deal with the US, with a baseline tariff of 15%. The current effective US tariff rate now stands at 18.3%, the highest in nearly 90 years. US Customs and Border Protection has collected more than double the tariff revenue year to date compared to last year, which will partially offset the significant tax cuts and fiscal stimulus in the One Big Beautiful Bill Act.
After losing its majority in the lower house in October, Japan’s Liberal Democratic Party narrowly lost its majority in the upper house. With Japan in political gridlock, calls are growing for Prime Minister Shigeru Ishiba to resign, and rating agencies are increasingly concerned about the long-term sustainability of Japan’s debt. The Bank of Japan’s refusal to raise rates kept the front end of the bond curve anchored, with Japan now experiencing the steepest yield curve among developed economies.

What are we watching?

Fed Chair announcement. President Trump may announce his nominee for the next Fed Chair in the coming weeks in what could be seen as an effort to undermine current Chair Jerome Powell’s authority. There appear to be four leading contenders: National Economic Council Director Kevin Hassett, former Fed Governor Kevin Warsh, Treasury Secretary Scott Bessent, and current Fed Governor Christopher Waller. A risk we are monitoring is whether market participants will start questioning the Fed’s independence, which could lead to a steepening of the yield curve and increased inflation risk premium.
Ongoing uncertainty, despite tariff reprieve, could hurt growth. While negotiations with large trading partners such as China, Canada and Mexico continue, global investors reacted with relief to the trade deals struck with other key countries. However, the lack of predictable trade policy globally creates a persistently challenging environment for companies (and therefore economies). Tariffs and other restrictions on the free movement of goods, services and capital are bound to make global supply chains more inefficient and, consequently, we are likely to see higher and more volatile inflation. The risk of stagflation is also increasing, as the growth-inflation dynamics in many countries hamper the potential response by central banks to downside risks in the economy, if inflation remains above target.
Fiscal sustainability, particularly in Europe. Governments worldwide have consistently been using fiscal policy to offset shocks to growth, and the influence of populist parties on government choices is translating to persistently higher government spending. The average G7 government deficit this year is likely to be around 6% of GDP — a scale normally associated with a deep recession — and average debt-to-GDP ratios have remained higher than they were pre-COVID. The deterioration in public finances seems structural, with little political appetite to consolidate government balance sheets. In this context, countries with higher and rising debt levels are more likely to face scrutiny by the market, especially if a large portion of that debt is owned by foreign investors.
USD volatility. In the wake of the April tariff announcement and ensuing market uncertainty, international investors have had to ask themselves whether they are comfortable with the extent to which their overall portfolios are denominated in USD or at least exposed to the US economy and markets. Marginal moves away from US financial assets through the repatriation of capital or changes in asset allocations can have a significant impact on currency markets, and we could be at the beginning of a long process of USD depreciation driven by cyclical factors (Fed cuts and weakness in the economy) as well as institutional concerns. For example, Taiwan has been a long-time investor in USD-denominated assets and its investors’ desire to hedge some of their international exposure away from the US could be one of the factors explaining the 7% appreciation of the Taiwanese dollar against the greenback in May. While no other currency can (yet) come close to the US dollar’s status as the reserve currency of the world, a steady shift away from US assets could see a persistent depreciation, interrupted by risk-off rallies such as the one we saw in July, when the greenback gained over 3% against a basket of G10 currencies. Expect more volatility ahead.

Where are the opportunities?

The risks of a recession have increased, yet tariffs are also likely to add to the current inflationary impulse. Given these dual risks, our key conviction remains a focus on higher-quality total return strategies that are less constrained by benchmarks. This could include global sovereign and currency strategies that have the potential to shine during these periods or unconstrained strategies that are able to navigate the late cycle by allocating across different sectors. These strategies could also enable investors to allocate capital away from cash and reduce reinvestment risk without taking on significant duration or credit risk.
In a still volatile and uncertain market environment, we see core fixed income, whether aggregate or credit strategies, as increasingly attractive from both an income and capital protection perspective. All-in yields remain attractive for investors looking to derisk following the equity rally seen since April. And for European investors looking to protect themselves from ongoing volatility, high-quality income may offer an attractive avenue not just in local but also global markets.
We think high-yield debt still offers potential, but advocate a cautious approach given market uncertainty and current spread levels. At the same time, the robust additional income potential may make high yield a good equity substitute should investors want to derisk. For all higher-yielding credit, we believe an “up-in-quality” issuer bias and careful security selection are warranted.

Expert

Marco Giordano

Investment Director

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