Fixed Income Forward: May 2024

Earlier this month Sweden’s central bank became only the second advanced economy, after Switzerland, to lower its policy rate. The US and euro area show no indications yet of any major weakness in their labour markets.¹ Inflation figures have also not yet hit targets in a sustained fashion, though the European Central Bank (ECB) seems to be getting closer and will most likely cut before the US Federal Reserve (Fed).²

Following the sharp repricing in rate cut expectations, the outlook for sovereign bond returns now looks more skewed to the upside. Some futures markets may now be underestimating the extent of policy easing ahead. Given that real (after inflation) rates are also in restrictive territory and putting some pressure on equity and credit valuations, the current environment provides more comfort for sovereign debt over the next one or two quarters. We are looking for additional catalysts to strengthen the case for US Treasuries. UK Gilts could outperform in the short term due to weaker UK economic data and earlier policy easing.

As the ECB looks set to begin its rate-cutting cycle ahead of the Fed, we currently favour the euro area over the US when it comes to yield curve steepening (eg, German 5s-30s). In general, the term premium on ultra-long government bonds is insufficient in our view. In contrast, we prefer the US over the euro area on real rates; the backdrop of heightened inflation volatility and attractive valuations should favour Treasury Inflation Protected Securities (or TIPS).

While core government bond yields are up year-to-date, corporate bond yields have risen by less. So whereas interest rate risk has held up, credit risk has come down when measured by the additional yield or spread offered by corporate debt. That lower yield premium does not seem to be dissuading bond investors much from buying up spread assets, including emerging market debt. Instead, locking in historically high yields looks like the overriding motivation driving strong demand for new bond issuance.

We think high quality corporate debt continues to make sense as a source of extra income in a context of generally solid corporate earnings, moderate default rate forecasts and anticipated monetary policy easing. This is clearly a “carry” story, especially for buy-andhold strategies, since investment grade spreads are unlikely to compress much further from here. We think bank bonds, particularly the more senior parts of the capital structure, are trading relatively cheap compared to other sectors.

Prospects for spread compression are low in high yield credit too, with perhaps the exception of Asia where current spreads may be overestimating the default pain that still lies ahead. In other regions, spreads are more likely to widen down the line, but falling rates can more than compensate and keep high yield total returns positive. We continue to put emphasis on carry, while being wary of high-capex, highly leveraged issuers. While we see credit selection as more important than any macro theme, generally we see B rated credits as more geared to economic growth and BBs as more sensitive to interest rates.

In emerging market (EM) external sovereign debt, gains this year have been driven mostly by frontier countries and debt restructuring. In recent weeks Zambia has made some progress in its bond restructuring programme, while there is still work to be done in Ghana and Sri Lanka. EM USD debt is trading relatively tight to US Treasuries (USTs) overall, but this has been driven by investment grade sovereigns. As trading in the asset class begins to broaden out, we see more value in EM high yield issuers where the macroeconomic direction of travel is gaining momentum, such as in Ecuador. While BB and B rated credits look to be priced fairly compared to history, we see more upside due to improving fundamentals and positive rating transitions.

Source: Bloomberg, ICE BofA and JP Morgan indices; AllianzGI, data as at 15 May 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.

1. US financial conditions
One of the catalysts we’re watching out for to strengthen the case for US Treasuries is tighter financial conditions, which could prompt the Fed to start cutting rates. However, the latest reading of the Chicago Fed’s National Financial Conditions Index³ suggests that it has gotten relatively easier for US companies to borrow, due to narrower credit spreads and rising equity prices.

2. UST and Bund spreads
If the ECB were to cut rates in early summer and the Fed in early autumn, that should not only help steepen euro area yield curves but also widen US vs euro area spreads. The magnitude of spread widening will very much depend on the trajectory of US inflation. If US disinflation stagnates, and Fed cuts are priced out of 2024, the 2yr Treasury-Bund yield differential may very well cross 330bp as it did in 2018.

3. Currency markets
Currency volatility is going through a period of relative lull as central banks have kept rates steady. Thanks to US economic strength and fading rate cut expectations, the USD has made gains against most other major currencies YTD. This trend may now have run its course, and being prepared to manage a possible resurgence in FX volatility may matter more for fixed income returns going forward.