Over the month of January, rates markets ended up at much the same point where they stood at the beginning of the year, but masking significant intra-month volatility. Usually, an inauguration would not be expected to cause much turbulence, as policy proposals should be well-understood and priced in. Not so with the Trump administration. In the days leading up to the inauguration, he announced a flurry of policy proposals around tariffs. However, observers were soon doubting his sincerity, leading to bonds rallying again.
All in all, the US 10Y fell by only 3 basis points. The German 10Y rose by 9 basis points, underperforming Italian, French and Spanish government bonds – perhaps reflecting uncertainty around the upcoming election. Credit markets were similarly unimpressed by tariff threats and spreads continued to grind tighter on both sides of the Atlantic, and both in High Yield and Investment Grade markets. As a matter of fact, the MOVE index – a gauge of bond market volatility – fell sharply.
Investors appear to have adopted “we’ll believe it when we see it” as their motto. Our takeaway is that markets are now more vulnerable to surprises and event risks.
We take a more prudent view on US rates and end our steepening trade
Last month, we held a neutral grade on US rates in spite of most drivers being negative in our view, as we saw Value being significantly present to not warrant an underweight position. Since then, we have seen a significant rally. Therefore, although the other drivers in our framework remain negative, Value is less present. We have seen that the rally came primarily from real yields, as breakevens have remained stubbornly elevated. This is noteworthy as the price of oil dropped significantly, leading to a breakdown in the usual oil-breakeven correlation. We can perhaps interpret this to say that markets clearly expect inflationary US policies, but this was (temporarily) masked by cheaper energy.
Growth remains robust, the consumer is still strong, and we are seeing stabilization in the labour market. Inflation remains rather sticky, despite the fact that a +0.16% MoM Core PCE was seen as a downside surprise. This level would not even be sufficient to get to 2% by mid-year. Therefore, even excluding possible tariff impacts, inflation seems to be headed towards stabilization at a level materially above 2%. That said, one element we will watch closely and that may support disinflation is shelter. The cost of new tenancies has fallen, which can be seen as a leading indicator for shelter costs including Owners’ Equivalent Rent, which is a CPI component.
We also ended our 10-30 steepening trade. Comments from Scott Bessent, the Treasury secretary, indicate a strong focus on the 10Y tenor specifically. This could accentuate the higher beta that the 10Y tends to exhibit vs. the overall Treasuries curve. As such, 10-30 steepeners tend to be somewhat directional causing the curve to flatten as Treasuries sell off, with the selloff being more pronounced for the 10Y than the 30Y. As we take a negative view on Treasuries overall, we therefore also prefer to end our steepener.
We maintain a positive duration bias on Eurozone rates
The Eurozone’s growth dynamics continue to be weak. PMI data has improved slightly but remains weak. Inflation is still in deceleration mode, and wage increases via sectoral bargaining are now mostly in the past. The ECB has continued sequential easing in a “meeting-by-meeting” approach without committing to further policy steps. Although supply and demand remain a headwind, we turn slightly less negative on this indicator as year-to-date sovereign deals have been heavily oversubscribed, demonstrating that investor appetite is present.
On a per-country basis, we retain our positive view on Spain, the sole large Eurozone issuer with healthy growth. We introduce a long Belgium vs. France. Although a budget has been passed in France averting immediate crisis, the performance on French spreads – with an OAT-Bund at around 70bps – leaves limited room for bad fiscal surprises, which remain entirely possible. Discussions on the pension reform and rating reviews ahead will also have to be monitored closely for France. In Belgium, on the other hand, a government has been successfully formed whose policy aims should be positive from a fiscal point of view. We therefore see more value in the latter.
Credit spreads are tight, but we think they may remain that way
EUR IG credit has continued to perform well, and spreads are close to the all-time lows that were supported by central bank policy. However, fundamentals remain healthy and technical support is present as well. Firms leverage has come down over the past five years. Although interest coverage ratio has also fallen as a result of higher rates, it remains at a healthy absolute level. We are now into the third year of higher rates and average coupons are not much lower than bond yields. Earnings growth has also been solid.
On EUR HY, we turned somewhat more positive, benefitting from a temporary uptick in spreads and widening vs. IG. We continue to find fundamentals stable and decent, and see technicals as a supportive factor with extremely thin issuance.
US Credit is undoubtedly expensive across most of the quality spectrum. Nonetheless, despite this richness, we are comfortable holding market-weight exposure to investment grade credit. This is thanks to high all-in yields and the buffer against possible spread widening this high carry offers. We also note a convergence between the A and BBB-rated buckets in the space. BBB fundamentals are holding up, as these companies were compelled to strengthen their balance sheets in anticipation of higher rates to avoid becoming fallen angels. On the other hand, higher-rated companies did not face this same pressure, leading to a deterioration of interest coverage ratios as they refinance.
High Yield valuations are arguably even richer, given these credits are intrinsically more vulnerable to event risks (e.g. tariffs) or economic slowdown, and therefore prefer an underweight stance. Fundamentals are still decent but trending weaker. However, high yields and low duration do offer a substantial degree of protection. Yields would need to rise by over 2% for investors to not see positive total returns by the end of year.
Subordinated Bank Debt: A hidden pocket of Value?
With High Grade and High Yield spreads at near-record lows, value in credit is increasingly elusive on both sides of the Atlantic – but we see subordinated bank debt as a corner of the market where it is still present. AT1s are trading at yields substantially above BB HY credit, while as recently as five years ago the reverse was true. We think investors have become excessively pessimistic following the SVB and Credit Suisse episodes of 2023. With strong bank profits, good asset quality, strong profits and risk transfers, we think these are some of the cheapest risk premia available in the market right now.
BOJ Monetary Policy: it’s actually about inflation now!
Generally, BOJ hikes have been priced when the Yen has been weak, but traders have not cut these expectations despite Yen strength. We have also heard hawkish comments from some BOJ members. This makes sense given the backdrop of an economy that has seen reflation beyond the global post-Covid spike. Traders are awaiting the results of the spring wage negotiations, which have tended to surprise to the upside in recent years and may do so again.
