Update Bonds: Is the US a friend or a threat?
Bond investors have been struggling to value the policies that US President Donald Trump may or may not implement. Yields moved up and down with every move on the global tariff playground, but there is still little to no visibility regarding the endgame and its impact on growth and inflation.
This week’s numbers more than confirmed that US inflation is sticky and perhaps already accelerating, while earlier numbers showed unemployment falling again. As the US Federal Reserve has to navigate these stormy waters, it is no wonder Fed Chair Jerome Powell is said to be in no hurry to cut rates; and the odds are increasing that he may eventually even have to raise rates first.
Europe seems to be next in line to find out what tariff policies are in store. This means all hands on deck, at a time when Germany and France still have to wait for months before an empowered government may (or may not) take over. In the end, this may again put much of the burden on the European Central Bank (ECB) to manage this crisis, one that is perhaps even compounded by issues related to the global climate, energy and defence. The result may be the ECB cutting rates by more than many now expect in the second half of this year.
While much is still uncertain and volatile, odds remain strong that European interest rates will decline as threats mount, while US interest rates could possibly rise. The difference between European interest rates and US interest rates is likely to increase significantly this year.
For European bond investors, this means that they should be careful in buying US dollar bonds, which includes most of the high-yield and emerging-markets bond markets. These risky US dollar bonds may not benefit from lower European yields, as European investment-grade bonds are expected to do.
If the spread between European and US yields increases by 0.5 to 1%, as we expect, this alone would be a relative disadvantage for the performance of risky US dollar bonds of 2.5 to 5%, annihilating their relatively higher yields even before currency hedging (around 2%) or defaults (1 to 2%) take their usual toll. This could even get much worse if spreads increase in an (unexpected) recession scenario. We therefore clearly prefer European investment-grade quality bonds over riskier US dollar bonds given this uncertainty.
Chris Huijs