Fixed Income Forward: January 2024

Rates scramble for cuts while spreads unfazed

Bond markets have begun 2024 with mostly negative returns, but the move looks modest against the magnitude of December’s rally. Calendar-year returns for US aggregate and US investment grade indices were negative until early November, only to close 2023 with gains of 5.5% and 8.5% respectively (see chart).

Futures markets continue to imply a strong chance of USD and EUR rate cuts commencing in the first half of 2024 and amounting to roughly 150bp by year-end.1 But there is a disconnect between market expectations (six 25bp US rate cuts in 2024¹ ) and policymakers’ guidance (three 25bp cuts² ).

Markets ahead on rate cuts?

It’s easy to see that disconnect as overhasty positioning by investors. However, an eventual slowdown in inflation now seems a question of when rather than if. Bonds stand to gain both from higher-for-longer rates or from multiple rate cuts amid a recession. The current risk-reward thus looks skewed in favour of adding to core bonds and to yield curve steepening.

Historically, aggressive rate cuts tend to coincide with central banks having to rescue the economy. But again US unemployment held steady at 3.7% in December.³ The euro area trend is even rosier, with the most recent November data showing seasonally adjusted unemployment at an all-time low of 6.4%.⁴

If not jobs, then major rate cuts in 2024 would seem to hinge upon downside surprises in consumer price inflation (CPI), which we don’t see happening in the next couple of months. Core CPI in the euro area eased further in December to 3.4% (3.6% in November), but including energy, food, alcohol and tobacco it rose to 2.9% (2.4% in November).⁵ Similarly, US core CPI slowed from 4.0% to 3.9% while all-items inflation jumped from 3.1% to 3.4%.

Fed winning rate cut race

We think the US Federal Reserve faces fewer hurdles to a rate cut than the European Central Bank. The Fed’s preferred inflation measure, Personal Consumption Expenditures, underweights shelter compared to CPI and could show a lower 2023 reading when published at the end of January. Also, labour data6 point to continued wage disinflation this year. In contrast, the euro area faces collective wage bargaining, which typically runs through to the spring. Before that process pans out, don’t expect the ECB to claim victory on inflation.

Source: Bloomberg, ICE BofA and JP Morgan indices; AllianzGI, data as at 11 January 2024. Index returns in USD-hedged except for Euro indices (in EUR). Asian and emerging-market indices represent USD denominated bonds. Yield-to-worst adjusts down the yield-to-maturity for corporate bonds which can be “called away” (redeemed optionally at predetermined times before their maturity date). Effective duration also takes into account the effect of these “call options”. The information above is provided for illustrative purposes only, it should not be considered a recommendation to purchase or sell any particular security or strategy or as investment advice. Past performance, or any prediction, projection or forecast, is not indicative of future performance.

Different growth paths are another factor. The US economy roared back in 2023 helped largely by consumer spending, which we see plateauing.

Add the risk of rising loan losses and the Fed could be excused a cut to ward off recession. The euro area is just coming out of a shallow recession and the ECB’s own projection of a recovery this year limits its room from manoeuvre.

Fundamentals keeping credit calm

Credit markets seem unfazed by this complex outlook (see Chart of the Month) even as rates markets scramble to foretell the future. There may be more to that resilience than just a backward-looking view on bumper earnings and extended debt maturity runways. CEOs have led this latest (corporate) profit-driven inflation episode and should be better placed than economic models to anticipate how and when the cycle turns. With further spread compression less likely, we see credit as a carry (spread plus roll-down) story for 2024, especially in high quality corporate debt.

1. Yield curve steepening
The 2yr-10yr US and German curves are, respectively, about 20bp and 40bp away from turning upwardsloping.7 Softer producer price index readings seem to have helped.8 This “un-inverting” can be sustained by a combination of continued disinflation and stable growth, while steepening may accelerate if fiscal deficits also push up longer maturity yields.

2. Red Sea stagflation risk
The re-routing of container ships away from the Red Sea mostly impacts the European economy through energy prices. A prolonged crisis could delay a rebound from 2023’s stagnation and hurt corporate margins by as much as 1.8% if they are forced to absorb higher input prices.9 Some manufacturers have already postponed production due to missing parts.

3. Q4 corporate earnings
So far it is mostly US banks that have reported, though we have seen some pre-announcements from major multinational companies indicating growing pressure on revenues. With largely downward revisions to analysts’ earnings estimates, a big question is whether margins can hold up despite sticky wages and fading sales growth.