Deep dive into fixed income markets

The global and increasingly synchronised monetary easing cycle is gaining momentum. Fixed income markets expect policy rates in the eurozone to fall back to close to 2.0% in the coming year, while long-term core sovereign bond yields currently stand at 2.25%. In the United States, policy rates are expected to land a touch below 3.5%, while the 10-year Treasury yield is hovering a mere 0.7% higher, at 4.2%.

This climate calls for some degree of caution on long-term sovereign bonds. There’s still a large supply of these bonds, and central banks are proactively cutting rates to avoid damaging their economies. Since quantitative tightening is still taking place (thus further reducing the demand for bonds), there’s a risk of upward pressure on sovereign yields. Besides, some amount of inflation premium seems warranted, as central banks are lowering their policy rates even though inflation hasn’t yet come back to the 2% target.

In contrast, shorter-term sovereign bonds appear more attractive. Should fears of a more serious economic slowdown resurface, the markets would price in a more aggressive cutting cycle, which would lower short-term yields. This central bank “put” on cyclical risk is one reason why we prefer corporate credit and emerging markets in the risk asset space.

In the United States, we believe the government bond yield curve will continue to steepen. In the eurozone, the acceleration in disinflation – which has finally led to headline inflation readings below the 2% threshold – and the Brussels-imposed fiscal austerity measures in Italy and France are penalising GDP growth. This should lead to lower core bond yields across the curve.

Regarding developed market government bonds, investors have been reminded that these markets are not just a rates story but that spreads matter, too. Concerns over widening fiscal deficits, notably in France, have been brought into broad daylight. We therefore suggest caution on eurozone government spreads across the board – and especially in France.

Credit markets are providing an antidote to the government yield curve configuration described above. The credit spread curve is positively sloped across the maturity spectrum, giving investors a way to mitigate the negative slope in government bonds and making the yield curve for corporate bonds much more attractive.

Technical factors are also supportive. Flows into this asset class have been massive, especially in strategies that are less sensitive to mark-to-market (e.g. target maturity funds) and where assets therefore tend to be less volatile. Issuances have slowed, yet remain firm. The number of rising stars is positive for the fourth year in a row.

Finally (and most importantly), fundamentals also appear to be better oriented. Economic growth is showing signs that it may well have bottomed out, given that both the Federal Reserve put and Chinese put are back. The expected falling cost of capital and looser lending standards suggest that default rates will stabilise (in the area of 4%). In addition, the bottoming out of economic growth also points to a more benign environment on the earnings front.

As a result, we’re positive on credit and on the fundamentals, owing in part to the carry (which ranges from 3.5% to 6.4% across euro-denominated segments). The main drawback relates to valuation levels; credit spreads appear relatively tight by historical standards.

We believe that local EM debt still offers very attractive risk-adjusted yields in the global sovereign debt segment. Local EM debt should benefit from an attractive carry – 6.4% at the index level – and from the potential for bond price appreciation as the Federal Reserve begins its cutting cycle, which should enable EM central banks to cut rates more aggressively than what’s currently priced in.

We believe real interest rates are too high in these economies, where disinflation is more advanced than in the developed world.

EM issuers offer attractive investment themes in the current environment and provide valuable decorrelation since local EM debt tends to move independently of risk-on/risk-off narratives (contrary to hard-currency debt and foreign exchange markets).

Yet careful selection will be key. In over 60% of EM countries, inflation is still above the central bank’s target or target range. The central banks of countries such as Brazil and Mexico have plenty of leeway to support economic growth if the outlook darkens, since real interest rates there are currently in the 5% to 6% range.

Inflation expectations have been trending lower on the back of ongoing disinflation. 10-year eurozone inflation expectations have even fallen below the 2% threshold for the first time since the spike two years ago. This (among other factors) has led to the first interest rate cuts by all but one G7 central banks.

However, by cutting rates now, while inflationary pressure remains present in several parts of the economy, aren’t central banks sowing the seeds of future inflation?

The Federal Reserve is cutting rates and has signalled it’s embarking on an easing cycle, even though indicators show that US GDP growth is running at more than 3% – i.e. well above its potential. China appears willing to stimulate its economy more drastically, which finally also includes traditional, proper cyclical stimulus. And whether in terms of tariffs or strikes, there’s a whiff of the late 1970s in the air.

In this climate, we prefer real rates to nominal rates – i.e. we favour inflation-linked bonds over nominal bonds as well as inflation break-even widening strategies.