The last month of 2024 was a difficult one for the markets. Most major rates markets sold off, with the US 10-year rising by 40 basis points. At the same time, risk assets offered relatively little respite. The S&P 500’s spectacular 2024 rally ran out of steam in December and similarly, spreads in high yield US credit also widened. However, some pockets of the market resisted, as US investment grade spreads held steady and risk premia in EUR investment grade, EUR high yield and emerging market debt decreased.
This shift in investor demands on risk-free rates was driven by a wholesale repricing of monetary policy expectations. Much of the increase in yields was indeed an increase in real yields, the returns on inflation-protected treasury securities. The markets moved to a more hawkish interpretation of the Fed’s intentions.
Nonetheless, 2024 is also an important reminder that we have moved out of the ultra-low interest rate environment. Average yields across the US Treasuries curve ended the year some 20 basis points above the levels they stood at twelve months prior[1], but still offered investors a positive total return. At these levels, we should remember that the carry from coupons can offer a real buffer against rate volatility, especially in higher-yielding segments of the market.
After the December sell-off that has continued into January, valuation is now a clearly a positive within our framework. That said, the growth, inflation and ultimately monetary outlook cannot currently justify a positive outlook. Our models suggest a probability of reflation of 80%, suggesting that disinflation is now no longer the most likely scenario. “Super-core” inflation is showing little progress downwards lately, and we now face a situation in which there is arguably a “base case” for modest reflation and a “risk case” for a strong uptick in inflation, depending on which policies President Trump actually intends to implement.
Growth also continues to look robust, and a modest labour market downturn appears to have stabilised. Consumer spending is strong, despite a personal savings rate that has actually increased. Only an increase in credit card arrears provides a possible early warning signal that needs to monitored closely.
The markets are pricing a single Fed cut by the end of the year and we think there is a very real possibility that the market will test a “no cut” scenario.
As much as the December rout was driven by the perception of a more hawkish Fed, in January the sell-off continued, with the difference between inflation-protected and nominal treasuries increasing – demonstrating that investors are also increasingly worried about the direct inflationary impacts of Trump’s policies.
The increase in Gilt yields was prominent in the press, leading some observers to question, perhaps not in good faith, if the UK is going through “another Liz Truss” moment. The difference, though, is rather clear in that yields on UK government bonds increased by a similar amount as their German counterparts over the past month and are instead being dragged along by global rates movements as opposed to an idiosyncratic UK event. However, given the limited headroom the UK government has against its own fiscal rules and the large current account deficit with the Gilt market exposed to “the kindness of strangers”, there is justified focus on the knock-on impact here.
As such, on UK rates, we return to a neutral stance, whilst initiating a short position on Sterling. Fundamentally, we continue to believe that market expectations for the terminal rate are too high relative to the other G10 markets at over 4%, however, we acknowledge that the market has not come around to this view. Instead, fiscal concerns appear to be at the forefront of investors’ minds, notably non-domestic investors, who cover some 30% of the UK’s funding needs.
Sterling has been supported by rates differentials until now but with fiscal concerns in focus and our conviction regarding lower terminal rates, we believe that there are multiple scenarios which could lead to an underperformance in the currency. As such, we implement a short position.
The eurozone is facing very sluggish growth, with only a few bright spots. The ECB also undertook some slight downward revisions to both its 2025 & 2026 growth and inflation forecasts. Regarding the inflation cycle, there are some risks to headline inflation from energy prices and a weaker euro relative to the dollar, but we expect core inflation, while still clearly above target at 2.7%, to move downwards in the months ahead. The disinflation trend is more firmly in place in the eurozone than the US, not least thanks to more long-term sectoral wage bargaining. We continue to expect a sequential approach from the central bank, with the March meeting being especially important – once the first steps of the US administration and the outcome of the German elections are known.
Aside from the “beta” risk of possible upward volatility in rates, we see supply and demand dynamics as a risk factor for Euro government bonds, with a very substantial pipeline coming to market to meet treasury needs. That said, we also see early indicators that there is a corresponding “thirst” for this issuance, with recent deals from Italy and Belgium being very well absorbed.
From a country perspective, we cut our underweight on France at Bund spread levels above 80 basis points, and with a relative degree of political stability in the short term, the risk of further substantial expansion is more limited. However, the price of any political stability may well be a further weakening of the fiscal situation, so this needs to be monitored closely. We continue to like Spain, which offers yield pick-up (albeit less than France!), and is the lone major eurozone economy with healthy growth.
In Norway, we see a central bank that has been lagging behind other central banks in the cutting cycle, with the Swedish Riksbank coming closer to an end and the ECB advancing steadily. Norway, on the other hand, is closer to the start of the process – as fears of fuelling Krone weakness previously held back the Norges Bank. With the NOK having stabilised, it will now have room to ease monetary policy. Market pricing for the terminal rate is probably excessively high at 3.75%, and contrary to the UK, fiscal worries present absolutely no concern in the case of Norway.
In the Czech Republic, like Norway, rate cuts are underpriced compared to the eurozone, in an economy that is tightly linked to Germany and therefore also likely to continue to suffer as a result of weak German growth. Fiscal concerns are also not a major worry.
Emerging Market Debt faces pressure as spreads tighten and US Treasury yields rise
Last month, we downgraded our outlook on Emerging Market Debt (EMD) Hard Currency (HC) due to tight spreads and rising US Treasury yields. However, spreads have continued to tighten, even further than anticipated. This trend is also evident in EM Corporates, where spreads have narrowed, both in the Investment Grade (IG) and High Yield (HY) categories. The key reason for maintaining a negative stance on EMD is the tightness of spreads. Sovereign spreads, excluding the CCC-rated market, are about two standard deviations below historical averages. This positions them in the “rich” territory compared to US credit, which is also at historically tight levels, making it less compelling as a buy opportunity.
As for EM Corporates, the continued tightening of spreads across both IG and HY has further pushed valuations into rich territory, aligning them closer to US credit levels.
In the Local Rates segment, the spreads over US Treasuries have continued to fall, while EMFX has underperformed vs the US dollar. China’s yields have consistently moved downward, further weighing on the broader outlook. We are neutral, given the current strength of the US dollar and tight yield spread with US Treasuries.
While we hold a neutral stance on US yields, the rise in US Treasury yields and the US dollar typically creates an environment where EM struggles. Furthermore, flows into emerging markets have been slightly negative, contrary to expectations of positive inflows. This contrasts with DM corporate credit, which has seen more stable inflows.
Chinese government bond yields have continued their relentless move lower, as markets have not shown confidence in the government’s efforts to stimulate the economy. Looking forward, we expect that the Reserve Bank will prioritise currency stability and have suspended bond purchases to halt the decline in bond yields, which have fallen to levels that are probably of concern to the central bank. Monetary policy has proved insufficient and real economic stimulus will need to come from the fiscal side.
In Japan, wages continue to rise and core inflation has ticked up. The BOJ should hike more, but the market is still hesitant and wondering if “this time, it really is different”. With a global environment in which other central banks are cutting, the BOJ’s scope for action has increased and we think they may well be more aggressive.
On Euro investment grade credit, we upgrade our grade from neutral to +0.5. Ratings drift continues to be very solid, companies still have strong balance sheets, banks in particular. Supply and demand should also be favourable. The beta of investment grade fund managers, i.e. the level of risk they are taking in their own funds remains low, indicating potential for further flows. While supply has been elevated, investor appetite has been very high with cash that has been on the sidelines eager to enter the asset class. As long as the Eurozone remains in a slow-growth environment that puts downward pressure on yields, but avoids a full recession, IG credit should remain very well-supported.
However, on Euro HY, we have downgraded our view from neutral. Yield pickup compared to investment grade credit appears simply too slim to justify the additional risk. Fundamentals are decent, but compensation is not enough in light of the asset class’s additional sensitivity to any negative incremental newsflow.
US credit spreads appear to have reached a “floor” at very rich levels. Fundamentals however remain strong and the macroeconomic outlook should continue to be clement for issuers. As such, we retain a neutral grade on investment grade credit, whilst we have an underweight on high yield, which is more vulnerable to event risk; the additional risk premium over investment grade credit is also very low, very much reflecting a similar situation as in EUR corporate credit.
[1] ICE BofA All Maturity US Government Index.
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