Update Bonds: Not the typical summer lull
During the month of August, financial markets typically turn a bit dull. Many market participants go on holiday, reducing market liquidity. In this summer lull, markets often trade sideways.
Investors returning from holiday this week, see ten-year Bund yields trading at around 2.3%; corporate credit spreads for euro-denominated investment grade at around 115 basis points and high-yield at around 360 basis points. These levels are not too far away from where they traded in late July.
But while markets may be largely back to where they were before the holiday break, there was, in fact, a short period of high market turbulence at the beginning of August. This was due to a disappointing US employment report that stoked recession fears and a surprise rate hike from the Bank of Japan, leading to an unwinding of yen carry trades. Risky assets sold off and US Treasury and Bund yields fell sharply. (When bond yields fall, bond prices rise.)
Some economists even started to push for an intermediate rate cut from the US Federal Reserve. In the end, the market panic lasted only a few days, thanks to a stream of better US economic data and the Japanese central bank calming markets about its rate-hiking path. Risky assets quickly moved back to fully pricing-in a soft landing for the US economy.
After witnessing this summer period, we believe that the Fed will begin cutting rates in September. We also think that recession risk has increased, as the cooling of the US economy could possibly go too far. A soft landing remains our base case, but we have increased the probability of a US recession to 30%. Market volatility may also rise again if data disappoints, as was seen after the release of weak manufacturing data. And the Bank of Japan’s normalization plans could drive US Treasury and Bund yields down and credit spreads up.
The US August employment report (to be published late Friday) will provide some insight. New labour market disappointment could definitely shake markets, although it may take months before a true picture of the US employment situation emerges.
With US elections in November, investors will need to pay attention, as the impact from a Harris (Democrat) versus Trump (Republican) victory could have very different market implications.