Good data is bad
More precisely, bad news for risky assets. This has become (yet again) evident after the market’s recent response to the strong US employment report earlier this month, which triggered a sharp risk-off move. To be clear, this is not an unusual phenomenon, as we have seen this pattern many times before. What this tells us, however, is that investors remain addicted to expectations of central bank cuts, at least for now. In other words, central banks, especially the Fed, continue to hold outsized market-moving power. But it will not stay that way forever. At some point, the Fed will play second fiddle, but not until the market has grown comfortable with the idea that the Fed easing cycle is almost over and that the US economy can deal with the level of interest rates where the Fed pauses. Until then, investors are bound to be subject to sharp swings in market rates and elevated levels of macro volatility. Where is the silver lining in all this? Markets do what they have always done: overshoot. At this juncture, Chief Economist Erik Weisman is of the view that future rate cuts may have become underpriced. Indeed, the market has gone too far pricing out the Fed policy moves. A stingy 17 bp or not even a full rate cut is penciled in for the rest of the year, which looks rather harsh. This is the good news—potentially: at some point, investors may come to the realization that the risk to market rates has become heavily skewed to the downside.
Curve steepening comes in all shapes and sizes
More often than not, curve steepening is a positive market development, as it typically signals that macro conditions are strengthening and recession risks are fading. Unless of course the steepening reflects more concerning risk factors. In principle, a more adverse curve steepening pattern can either be the cause of rising inflation risks in the face of a weak-credibility central bank, or rising fiscal risks in the face of weak-credibility fiscal authorities. In the view of our head of DM debt sovereign research, Peter Goves, the latest market moves mainly reflect vulnerability in sovereigns with limited fiscal room, including in the UK. 10-year gilt yields have skyrocketed by over 60bp over the past six weeks, triggering a sharp steepening of the curve in the process. But the UK is not alone. In France, the 2s10s on the OAT curve is now trading near 100bp, mainly reflecting investor concerns over rising fiscal risks over there as well. Meanwhile in the US, the UST curve may also have steepened, but the move is probably less about fiscal worries—at least for now—and more about strong growth, together with sticky inflation. When looking at the decomposition of the market moves that have underpinned the US10yr rates upward trajectory since early December, one can indeed see that it has been driven by 2/3 higher real rates—which tend to be associated with stronger growth expectations—and 1/3 higher break-even inflation—which signals the pricing of higher inflation risks. Overall, all the market excitement appears to occur in the rates and curve space these days, while it is worth noting that credit spreads remain well-behaved, both in the US and in the Eurozone. Despite elevated rate volatility, investors seem to stick to the very reasonable view that credit fundamentals remain robust, which is good news for fixed income.
Also read: Betashares CRED ETF Surpasses $1 billion in FUM
The US is open for business
One of the key impacts of the ongoing easing cycle across the globe is that hedging costs have changed dramatically over the past few months. In particular, the US credit market used to be unattractive for the EUR-based investor who wanted to hedge the currency risk. Not anymore. In IG, the EUR investor can enjoy a yield of about 3.40% when gaining exposure to EUR credit, or a yield of 3.85% when seeking to buy US IG credit after hedging the USD risk. This is because the cost of hedging the USD has declined to 1.66%, well below what was in 2022 or 2023. The same story applies to the Japanese investor who may now find more attractive yields in US IG after having hedged the cost of USD exposure. Specifically, a JPY-based investor can currently collect a yield of 1.36% in US IG, net of hedging cost, which is a bit higher than the 1.23% yield offered by the Japanese IG market. Overall, it seems that the normalization of hedging costs is helping expand the size of the investible universe for the non-US credit investor, with access to US IG becoming more attractive from an FX-hedged yield perspective. Of course, there is an entirely different topic which may also be relevant here, which is the decision to currency-hedge or not hedge the exposure to US assets. The dollar has been on a tear, so for the global investor who has that flexibility, embracing some currency risk along the way may make a lot of sense.
