Quarterly Outlook
Macro Outlook: The US rate cut cycle has begun
Peter Garnry
Chief Investment Strategist
The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
Bonds on everybody’s lips
Althea Spinozzi
Head of Fixed Income Strategy
Summary: Markets are expected to experience volatility in 2024 due to weakening growth, declining inflation, and geopolitical tensions. Central banks are likely to hesitate to cut rates aggressively, leading to uncertainty in bond markets. Investors should focus on high-quality sovereign bonds, while selective investment in corporate bonds could be considered.
Weakening growth, inflation, and a shaky geopolitical environment
Markets should be ready for another bumpy ride in 2024. Although sluggish growth and declining inflation have set the grounds for lower interest rates, monetary policy uncertainty and geopolitical tensions will remain.
As central banks started hiking policy rates aggressively, the probability of a recession increased among leading economists and bond futures priced prematurely a soon to come cutting cycle. However, central banks stuck to their “higher for longer” narrative upsetting markets throughout 2023. Fast forward, and policy rates have risen to their highest level in more than fifteen years. Despite economic woes, policymakers are not expecting to cut rates aggressively in 2024. However, a recession in the US economy could quickly change this.
A fragile geopolitical landscape will add to market volatility. The US is facing geopolitical tensions in Ukraine, Israel, and Taiwan. With the US going to the polls in November, the political situation will likely move to a gridlock in 2024, lowering the fiscal impulse and adding to growth uncertainty.
The above calls for caution from central banks when tightening the economy further or easing it too quickly, implying higher volatility in bond markets.
The bond market offers attractive prospects for investors
Bond investors are presented with the opportunity to lock in one of the highest yields in more than ten years. Higher yields do not only mean higher returns, but also a lower probability of bonds posting a negative return even if yields rise slightly again.
With central banks likely cutting rates slowly, the lagged transmission of aggressive monetary policies from 2023 will continue to tighten financial conditions in the new year. This would favor extending duration and quality in the medium term.
There are three possible scenarios for developed market sovereign bonds in 2024:
- Soft landing scenario: the battle against inflation is over, and a deep recession is avoided, causing central banks to cut rates slightly, but not aggressively. Yield curves would bull steepen, with 10-year yields adjusting moderately lower from where they are today.
- Hard landing scenario: a deep recession forces central banks to cut rates aggressively, provoking a deep bull steepening of yield curves. Rates would fall considerably across tenors.
- The 70s scenario: inflation reignites, forcing central banks to hike again. This would see yield curves bear flattening, with front-term yields offering a considerable pickup over long-term yields.
Quality is king
Deteriorating economic activity and high rates do not bode well for risky assets, which could lead to higher corporate bond spreads amid slowing revenues and compressed margins.
While yields on corporate bonds in the US and Europe have risen together with sovereign yields, the pickup that investment-grade corporate bonds offer over their benchmarks is well below the 2010-2020 average.
When looking at junk, the picture is even more depressing. USD high yield bonds pay 260 basis points over comparable investment grade bonds, a level in line with pre-Covid valuations when the Fed was stimulating the economy through quantitative easing and interest rates were less than half what they are today. In Europe, junk pays 310 basis points over high-grade peers, reflecting a more challenging macroeconomic backdrop.
Therefore, we see better value in developed market sovereigns, although a selective approach for corporate bonds remains compelling.
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