Update Bonds: Waiting for the Fed
US core inflation (which excludes food and energy costs) unexpectedly picked up in August, reinforcing the idea in investors’ mind that the Federal Reserve will cut its policy rate by 25 basis points at its next meeting, instead of opting for a more aggressive 50-basis-point cut.
However, this did not have any consequences on the downward trend US Treasuries are experiencing since early September. As expected, the European Central Bank (ECB) decided to cut its policy rate by another 25 basis points at its meeting on Thursday, after the 25-basis-point rate cut in June. Policymakers maintained their inflation outlook and did not commit to further rate cuts. The impact of this week’s rate cut on European government debt was somewhat negative, with yields edging up in the aftermath of the ECB meeting.
How did markets react to the latest economic data? In recent weeks, we have witnessed some concerns regarding the economy, following weak US job numbers. As a result, spreads widened slightly across the board. More specifically, US investment-grade corporate spreads are back at the level of around 100 basis points, due to worries about the economy. For most of this year, these spreads had been below their historical average, driven by a robust economy and improving financing conditions. In Europe, recent economic data had a more subdued effect, with only a slight widening of spreads. Current European spreads are at 123 basis points, well below their historical average and about 15 basis points lower year-to-date, as investors expect the ECB to take a dovish approach.
In recent weeks, spreads on lower-rated US high-yield bonds widened, although they remain well below their historical average. In Europe, a similar trend was observed: spreads moved higher, back to where they were at the beginning of the year, but are still well below their historical average. As mentioned in previous publications, higher yields still seem very attractive. However, we remain cautious, given the probable impact of higher rates on risky assets. We also believe high-yield bonds are still expensive. Therefore, we prefer safer higher-quality bonds which offer relatively attractive risk premia.
With regard to our allocation to the high-quality bond segments, we keep an overweight position in European corporate bonds and a quasi-neutral position in government bonds. Furthermore, we still favour European long-maturity core sovereign bonds, which should benefit in the coming months from lower yields. Within our allocation to the riskier high-return bond segments, we maintain a neutral bias towards emerging market debt and a negative one for high-yield bonds, considering current spreads as too tight given the economic backdrop.