Central banks were out in full force in September, with the Federal Reserve implementing a meaningful 0.5% rate cut, while the ECB continued its easing cycle with a cut of 0.25%. Rates rallied sharply over the first half of September, as the theme of disinflation and rate cuts continued, while the second half saw central bankers’ comments and incremental economic data releases translate into strong revisions in Fed and ECB policy trajectories.
The ECB cut rates by 25 basis points at its latest policy meeting, preferring progressive action as confidence increased that inflation will converge to target by next year. Christine Lagarde signalled the possibility of two more similar-sized cuts for the remaining two meetings this year. However, policymakers highlighted that the next decisions depend on whether inflation progresses as projected, and that flexibility on the pace of policy normalisation, in both directions, is necessary to account for changes in economic growth and inflationary pressures. The ECB revised its growth expectations downwards for 2024 and 2025, as the eurozone’s economy continues to lose momentum, led by material weakness in France and Germany. Services slowed, as households no longer seem to be supporting the growth momentum and the manufacturing base remained under pressure from the slowdown in export markets.
Across the Atlantic, the Fed opted for decisive action and cut rates by 50 basis points, emboldening rates traders to price more rate cuts down the line despite Jerome Powell’s push-back against the idea of sustained large cuts in the future. With the economy humming at an annualised growth rate of 3% over Q2 2024 and the job market only slightly cooling, the Fed has shown that it is concerned about falling behind, as data shows that the US consumer appears to be rapidly losing confidence because of concerns regarding the labour market. The Fed’s decision raised questions about the economic cycle and its data dependence implies more rate volatility lies ahead.
On the corporate front, issuers printed close to EUR 80 billion in debt over September, the second largest on record (after 2019), frontloading to avoid November election volatility and taking advantage of strong investor demand. All in all, however, the credit market remains supported by strong reinvestment demand and fresh inflows in investment grade funds, as lower central bank rates drive demand for higher quality fixed income. However, as the market has priced a significant amount of policy easing already, we have observed a shift in appetite for duration, with strong demand for the front end of the curve.
Structurally, we have been positive on duration throughout the year, while tactically holding a neutral stance on the back of the extended pricing of rate cuts. However, after the important uptick in yields over the past few weeks (more than 30 bps) , we will hold a prudently positive view again, considering the number of rate cuts priced (aligned with the dot plots). as well as the fact that inflation appears to be well under control. We expect cuts of 25 bps in each of the next two Fed meetings, as priced by markets.
In terms of growth, we hold a more balanced view, with significant evidence that the labour market appears to be cooling (in spite of a strong recent NFP number) on the back of a decline in hiring rates and even hints of a layoff cycle. The ISM manufacturing continues its (albeit modest) contraction, but we have not had any alarming data prints, as the economy appears to be trudging along towards a soft landing. In terms of inflation, we see downward trends that point towards disinflation. Data on wages also shows that we appear to be headed to an inflation level of around 2%. We do not see commodity/oil prices weighing too heavily on inflation, considering that in spite of geopolitical risks, OPEC+ seems intent on increasing supply, which should act as a downforce for prices.
The key elements of risk are obviously the US elections, the outcome of which still appears to be too close to call. Indeed, the probability of a Trump victory along with a Republican Congress appears to be low, but is clearly one that is likely to push rates upwards significantly and we continue to monitor this closely. We are also carefully following the potential impact of Hurricane Milton (in Florida), where the damage and displacement of the population is likely to have an impact on growth and inflation.
We have initiated a short position on Swedish rates vs EUR rates. The Swedish economy has underperformed in growth terms this year, but a large degree of negativity is already priced in. While Sweden is clearly experiencing disinflation, the moves towards lower inflation in the eurozone has seen some narrowing in the inflation differential between the two markets. The recent stabilisation in the Swedish krone is also a positive on this front. Finally, with expectations of 100 bps of cuts over the next three meetings and the Riksbank having already cut by 75 bps so far this year, we don’t see a large risk to faster cuts.
While our value indicators have turned neutral, the cycle and technicals are positive. In terms of the business cycle, we expect a fresh contraction in the 3rd quarter, resulting from downwards revisions in PMIs and a weaker job market, which point towards more sluggish growth ahead. On the inflation front, deceleration continues as headline inflation has now moved below 2% for the first time in three years. Core inflation dynamics have also slightly decelerated and this movement is expected to be more significant in 2025, which also supports our positive stance on eurozone duration. The ECB continues to operate on a data-dependent, meeting-by-meeting approach. Central bank members are increasingly pointing to a rate cut in October, citing growth concerns and confidence that inflation has been brought down. However, we do not expect any pre-commitment to accompany this rate cut, while the markets are pricing a rate cut at every meeting through March 2025. Flow dynamics are supportive, with many countries having already issued close to 90% of their annual needs and the pace of supply is likely to decline over the fourth quarter.
We previously held a negative stance on French duration. From a valuation perspective, with spreads moving towards 80 bps over the course of September, we have decided to tactically take profit on our underweight stance. We continue to monitor the measures taken in terms of the budget as well as the political situation, which remains relatively fragile, and we note that the country is under acute rating agency scrutiny. We also stand ready to reinitiate a potential short if valuation/spread levels adjust below 70 bps.
Elsewhere, we have taken a neutral stance on Euro breakevens, by taking profit on our underweight in our inflation strategy. The carry remains negative but other drivers are more mixed than in the past.
On EUR credit, we see some degradation in fundamentals on the back of weaker macro data, and we see dispersion increasing. On investment grade, we retain our neutral stance, as yields continue to entice investors to pile into the asset class. Fundamentals remain resilient, but we are seeing pockets of deterioration, namely with the auto sector suffering considerably. With considerable levels of geopolitical risk and the US elections approaching, we consider that caution needs to be exercised tactically in respect of an asset class that we continue to favour in the long run.
With spreads at fairly low levels, we hold a neutral stance on Euro high yield, though we consider it to be a better asset class than US high yield. While overall quality is strong, we see yields moving considerably lower and becoming less enticing for investors.
We continue to favour a long dollar, with the US economy continuing to surprise to the upside and the greenback likely to act as a hedge against a potential Trump victory in the US elections. The USD is already rebounding over the month of October. We aim to hold long USD vs the EUR as well as the CHF, where macro data and inflation data are weaker.
We also continue to favour the yen (vs the euro) as it appears to be cheap in a global easing cycle (with lower yields) and the currency remains a hedge against geopolitical tensions. Furthermore, the tightening cycle in Japan doesn’t appear to be over, with some probability of further rate hikes.
EM HC sovereigns have seen a volatile period, with spreads now at relatively tight levels, though we recognise that the carry level is quite high. Fundamentally therefore, our neutral position remains unchanged, despite healthy fundamentals in terms of the macro picture and in particular the US easing cycle we are entering into. In light of the US elections and the volatility it could bring to the asset class, we believe that this neutral stance is prudent. For EM corporates, we similarly see strong corporate fundamentals (indeed, better than most developed market peers) counterbalanced by, again, rich valuations.
In local currency, we may begin to see dynamics in terms of the global easing cycle that could be favourable to the segment, but prefer to wait for more clarity and clearer catalysts, with risks on the dollar and rates being the primary elements to monitor.
The recent fiscal stimulus from China has not gone unnoticed, and we believe that this will account for 1% of the GDP in its current form. However, there is a lack of detail regarding how this will be implemented, which is essential to determining how lasting and impactful it will be in lifting consumer confidence. Structural issues such as the ageing population, consumer confidence, high youth unemployment rates (~25%) and a weak social security system will require more than just central bank easing and scattered fiscal policies. We continue to hold our short position on local rates as well as the currency.
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