Update bonds: As good as it gets?
In June, spreads on corporate bonds (both investment-grade and high-yield) and emerging market debt managed to tighten even further. This occurred despite some weakening in US economic data. (The Citigroup Economic Surprise Index turned negative for the US in June.) Spreads are now below the levels of ‘Liberation Day’ and close to historically record low levels in many segments of the market.
At the same time, US Treasury yields came down by about 15 basis points across most of the curve. The weakening in economic data led to expectations of more rate cuts from the Federal Reserve this year. Meanwhile, the longer end of the curve was not impacted by the ‘big, beautiful bill’ making its way through the House and the Senate, even though this could be concerning from a debt sustainability perspective.
Altogether, we judge that markets have moved to fully price in a ‘goldilocks’ scenario, which means a macro-economic backdrop where growth is moderate (maybe below potential but not negative), inflation is stable and under control, and unemployment is low. This scenario is as good as it gets for companies and investors.
This could happen, and the latest job report released this week confirms that the labour market remains strong for now. Yet, we believe the risks are high. The weakening we’re seeing in US economic data may just be the beginning, as companies appear to remain cautious in terms of capital expenditures and hiring activity, while retail spending is slowing. Companies seem to be absorbing the impact from tariffs so far but ultimately they will pass higher prices through.
Investor sentiment has been supported by what is now known as the ‘TACO trade’ (Trump always chicken out). New volatility spikes may be contained as long as this narrative prevails, however renewed volatility due to actions from the Trump administration should not be ruled out. Financial markets are believed to be the main reason that President Donald Trump started pulling back on his tariff agenda. Next week the pause on reciprocal tariffs expires, and with markets this strong, Trump may feel empowered to take a harsher stance again. Meanwhile, the ‘big, beautiful bill’ was passed by the Senate and the House. This may once again raise concerns about the debt sustainability among US Treasury investors.