Head of Fixed Income Strategy
Summary: With the economic slowdown, quality assets will gain favor, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
A slowdown in economic growth and a gradual decrease in inflation will give central banks the opportunity to dial back on their tight monetary policies and implement rate cuts as soon as in the second quarter of the year, building the case for a portfolio's extension in duration.
Despite this, investors should refrain from getting too much exposure to bonds with ultra-long maturities as inflation remains above the 2% target. Monetary policies in developed markets will start to diverge in terms of balance sheet unwinding. In addition, the Fed will slow the pace of Quantitative Tightening (QT) to avoid a liquidity squeeze, and the ECB will accelerate it, beginning to runoff the Pandemic emergency purchase programme (PEPP) in June. This is likely to result in higher volatility in bond yields, especially in the longer part of yield curves.
Following a broad, cross-market rally over the past two quarters, markets might be underestimating both the upside and downside risks to the economy. The good news is that fixed income markets currently provide a variety of opportunities that can withstand multiple macroeconomic scenarios, thanks to attractive bond valuations and yields that are around their 15-year highs.
Despite fiscal concerns, sovereign bonds continue to demonstrate their value as a portfolio hedge against growth and financial risks, with the front part of the yield curve offering a win-win solution.
The Fed and ECB are likely to begin cutting rates around summer. Yet, policymakers will reinforce the message that they remain data driven and will proceed slowly as inflation remains above the 2% target.
If rate cuts do not materialise, a hard landing becomes more probable, particularly in the Euro area, where the economy has been stagnant since December 2022.
Credit deterioration will accelerate as the economy slows, resulting in rating downgrades. Excluding pandemic highs/lows, investment-grade corporate bonds currently have the highest leverage on record, and the lowest investment coverage since the global financial crisis, making bottom-up analysis and cherry picking crucial.
The high-yield corporate space is facing a double hurdle: deteriorating fundamentals, and increasing refinancing risk, as they approach a wall of maturities in 2025. Yet, as central banks prepare to ease financing conditions, junk bonds are likely to remain underpinned.
As the Federal Reserve and the ECB prepare to cut rates, there is scope to extend a portfolio’s duration up to 10 years.
Developed markets front-term rates have peaked in 2023 and offer a win-win scenario for medium-term and long-term holders. As an example, assuming a 6-month holding period, 2-year US Treasury yields need to rise above 6.1% to provide a negative return.
US long-term rates remain vulnerable to the pace of inflation returning to 2%, and a possible rebound in term premium. In case of a slower than expected disinflation trend, yields of US Treasuries with maturity more than 10 years might rise further despite the Fed beginning to cut rates. In Europe, long-term rates are fair, but we remain cautious on ultra-long maturities.
Despite credit fundamentals deteriorating, investment-grade credit spreads will remain range bound as investors rotate from risk to quality.
High-yield spreads are likely to widen gradually amid a slowing economy. Yet, demand is likely to remain robust as, on average, junk bonds on both sides of the Atlantic pay a yield above the past 14 years’ average.
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