Steepening curves across the board

The bond markets in March were already abuzz with talk of tariffs, as the Trump administration implemented previously delayed tariffs on Canada, Mexico and China. Even more importantly for global markets, investors began focussing on April 2, touted by Donald Trump as “liberation day” – the announcement of allegedly “reciprocal” tariffs. Even before the actual announcement, investors showed signs of worries of lower global growth. Risk assets already began to show some slight softness, and credit spreads increased. On the other hand, eurozone rates initially spiked by nearly 50 basis points and then moved back off of the highs that followed the 1 trillion German infrastructure and defence spending announcement, as growth fears began crowding out concerns of higher supply.

The April 2 tariff announcement was a shock to most investors both for their extent and seeming randomness, which the Trump administration explained as taking into account “all trade barriers”, including, for instance, Value Added Tax. Stock markets duly sold off globally, and credit spreads – especially on High Yield – expanded substantially. The reaction from rates markets was more curious. Eurozone rates had already rallied somewhat in anticipation and continued to do so, especially on the short end of the curve – essentially bringing forward expectations of ECB rate cut timing. In the US, there was a brief dip in Treasury yields, but afterwards US government debt actually sold off. Curves steepened across the board.

What is happening in the Treasury market?

US Treasuries experienced their worst week since 2019. This is presenting investors with a puzzle and some clues, but no definitive explanation. US assets have found themselves in an “everything selloff”, affecting the US Dollar, Treasuries and Risk assets such as credit and equities. Specifically, why have the supposed “safe havens” of the Dollar and Treasuries not rallied as risk assets sold off? Commonly suggested explanations include liquidation of Treasury holdings to meet margin calls, futures basis trade unwinds, and Chinese holders selling in a retaliation – or perhaps just other investors front-running a possible Chinese selloff. In all likelihood, it is probably a combination of these factors and some others. It is also worth focusing on what probably isn’t, so far, an explanation: inflation expectations. As a matter of fact, inflation breakevens – the difference in yield between nominal and inflation protection Treasury yields, have fallen. Given a lack of recent historical experience of any tariff increase of this magnitude, modelling the impact of tariffs on inflation is indeed difficult, but we do expect the effect to be inflationary, at least in the short term. Consumer expectations also suggest higher inflation. Inflation breakevens are trading like a risky asset: falling and rising with stocks and oil. This lack of a clear explanation that fits commonly-held expectations of bond market behaviour leaves plenty of room for speculation about US government debt losing its safe haven status. At this time, we think it is too soon to make such a call, but developments require close attention and we prefer a very prudent and tactical approach as long as this veil of uncertainty is in place.

With a cloudy eurozone outlook, we are buyers of duration

The picture in the eurozone is far less ambiguous. Weak growth and disinflation was previously already our base case for the bloc. Tariffs clearly put further downward pressure on growth and inflation. Deflationary pressures can be expected not only from a weakening economy and demand, but also from the strengthening dollar – normally, a weakening Euro vs. the US Dollar would be a more typical market reaction. Lastly, extremely high US tariffs could cause other exports to seek to flood other consumer markets instead, pushing prices down further. We therefore increase our long bias on Euro rates. Currently, yields are still above the levels seen before the announcement of German fiscal stimulus. We feel that the bond market has not yet sufficiently priced in recession risks throughout the curve. More repricing has already taken place on the very short end of the curve, and hence we choose to add exposure at the 5Y tenor.

Euro rates can be further supported by relative value. Bund yields are now considerably higher than Treasury yields hedged to Euro, given the significantly larger interest rate differential between the US and Europe at the short end rather than the long end. The yield curve in Europe is now notably steeper than in the US, partially due to an increase in the term premium.

In keeping with the theme of positioning our portfolios for a lower-growth scenario, we prefer to rotate out of exposure to non-core countries into core countries. As such, we reduce our overweight on Spain and go underweight on Italy. In a risk-off scenario, we expect Germany to benefit the most. Fundamentally, we do still see Spain as a strong issuer, but investor sentiment will likely cause Spanish bonds to rally less than German bonds in the event of a flight to quality.

Credit has seen some repricing already, but we prefer to remain cautious

We have downgraded our rating on both Investment Grade (IG) and High Yield (HY) by half a notch each, due to significant increase of risk of further widening in both sectors. Currently, there is a lag between European and US high yield markets, making them very similar in terms of spreads. We do continue to favour investment grade bonds, relatively speaking, as the risk of outflows is more limited in this sector as investors de-risk.

For Additional Tier 1 (AT1) bonds, we advise a more cautious approach, as this asset class can be quite volatile. In terms of sectors, we are concentrating on local players and domestic companies, aiming to avoid exporters and focusing on defensive sectors instead.

Regarding spread levels, we would consider a more positive outlook on Investment Grade bonds at spread levels of 140 to 150 basis points (bps). For High Yield bonds, a more favourable range would be between 500 and 600 bps. In the short term, we tend to marginally favour European High Yield and credit, as we expect the impact on fundamentals to be more negative for US companies and consumers, leading to a likely outperformance of European credit.

We prefer local rates in Emerging Market Debt

Spreads coming into the tariff announcement were extremely tight, and we previously held a very negative view of valuations. There has since been a significant widening. We are now close to 400 basis points (bps), a level at which the asset class has historically been viewed as attractive. Consequently, the outlook is now more neutral and benign going forward on valuations. On the other hand, of course, the fundamental picture for emerging countries has become more difficult as well, especially for those countries with significant US exposure. That said, this could be mitigated somewhat if US Dollar weakness persists.

However, for Local Currency (LC) debt, falling inflation presents a positive aspect, as it opens up the possibility for rate cuts. On the LC rates side, there is definite scope for central banks to cut rates, especially with falling US rates, as some economies might need this boost. Another positive factor for local rates is the situation in China. If China continues to be weak and puts spare capacity onto global markets, it could lead to demand destruction. We have held the view that Emerging Market currencies should fare better with a weaker dollar, but we remain attentive to a possible return of the Dollar acting as a “risk-off” currency.

In any event, we see the tariff situation as probably creating idiosyncratic opportunities. Some issuers, notably in Asia, are highly vulnerable. Other countries may also try to exploit the situation, leading to a reallocation of economic capacity across emerging markets.

Risk-off currencies can continue to outperform

In the Forex market, our strategy is to go long on the Japanese Yen against the Euro and Sterling. The decision to go short on the British Pound is based on the observation that positioning is quite long, and we expect the Bank of England (BOE) to cut rates more than what the market is currently pricing in.

Risk haven currencies, such as the JPY and the Swiss Franc (CHF), are performing well. However, the overall positioning in JPY is long, which is something to monitor closely.