Update Bonds: Is the “Goldilocks” scenario over?
Last week, investors got a rude wake-up call interrupting the dream of a global ‘Goldilocks’ scenario, where both inflation and growth are not too high and not too low and central banks would be allowed to sit back and enjoy the ride too, despite a significant rise in geopolitical risks. But with tensions in the Middle East escalating, a hawkish rate hike by the Bank of Japan spooked speculative “carry trade” investors, who pay for their positions by borrowing cheap Japanese money.
The main blow was dealt on Friday, 2 August, in the US, when a disappointing number of new jobs and an acceleration in the rise in unemployment in July finally confirmed the weakening trend that was already visible in a broader range of US labour market indicators over the last few months. Suddenly, recession fears returned to financial markets and the Fed will likely further shift its attention from inflation risks towards economic growth risks.
The US Federal Reserve policymakers are almost certain to start a new rate-cut cycle at their September meeting. Although the market may have overreacted to recent developments in the short run, this has been a good moment for investors to buy bonds for the longer run. A year from now, US bond yields are expected to be considerably lower than they are now, even if the deterioration of the US labour market does not accelerate further. We expect the Fed to keep cutting rates by 25 basis points per meeting until they reach 3% in November 2025. A steady pace may help the Fed avoid being entangled in the political turmoil of the US elections in November.
Rate cuts by the Fed will make it easier for the European Central Bank (ECB) to continue their own rate-cut cycle that started in June. Recent inflation indicators were a bit higher than expected, but leading growth indicators fell again last month. We continue to expect that the ECB will also cut rates by 25 basis points at every meeting from now on. Investors in European bonds can continue to benefit from lower bond yields in the early stages of a rate-cut cycle, that will soon be joined by rate cuts in the US. Rising risks of a US recession, however, should keep investors cautious before adding global credit risk, despite the recent jump in risk premiums.
