The five factors that are driving fixed income right now

We take a look at the factors that will set the pace for the fixed income market over the coming weeks:

1) Rate cuts delayed. We are now two months into 2024, and it doesn’t look like central bankers are ready to make changes to policy rates, or at least not as early as markets thought at the height of December’s rally. By the end of last year, investors were predicting the first cut in policy rates to occur in the coming weeks, with the Fed leading the way. By the end of February, markets had taken out three of the cuts previously priced in, and now expect the Fed to start reducing policy rates in June at the earliest.

While it is clear that inflation has peaked and is on a downward trajectory, central banks are looking for reasonable assurance that inflation is trending towards 2%. So far, economic indicators have remained resilient, telling investors that we are not yet seeing significant slack generated in the global economy. Minutes from the January FOMC meeting revealed a certain uneasiness about cutting rates too aggressively given upside inflation risks. In an interview with the FT in early February, the ECB’s Schnabel was explicit about the risks of cutting too soon: “we must be patient and cautious because we know also from historical experience that inflation can flare up again.” Similarly to the US, markets are pricing in a delayed start to the rate cutting cycle for the Euro Area.

2) Economies (re)accelerating. A delay in rate cuts is seemingly vindicated by cautious optimism surrounding the global economy. Emerging markets continue to grow and developed markets are likely past the trough in the cycle after a slowdown in the second half of last year, which saw a handful of countries narrowly avoid or enter a very shallow technical recession. The resilience of the US consumer in 2023 allowed the US economy to continue growing despite a very significant hiking cycle. However, the pace of growth has started to slow, with both manufacturing and services ISM weakening over the last month, to 47.8 and 52.6 respectively. This is in line with market expectations of a soft landing, so much so that a ‘no landing’ scenario (where the US avoids a recession altogether) cannot at this point be excluded from the distribution of outcomes.

Investors are closely watching developments in Europe, which is seeing something of a reversal of fortunes from last year. The UK continues to accelerate into a negative supply shock (unemployment is at a 50-year low), with services PMI coming in at 53.8 and fiscal policy expected to loosen further ahead of the election later this year: this has significant implications for the Bank of England and market participants. In the Euro Area, despite increasing divergence between the fortunes of Germany and the rest (more on this below), economic releases are increasingly upbeat, with Citi’s Economic Surprise Index turning positive this month for the first time since Q2 last year, meaning data releases are coming in stronger than expected.

3) China slowdown. Chinese Lunar New Year on 10^th February marked the start of the Year of the Dragon, and this holiday is typically marked by extensive domestic travel and consumer activity. This year was also the first unaffected by Covid restrictions, but data somewhat disappointed, as consumption per capita trailed 2019 levels despite record numbers of people traveling across the country.

Investors’ unease around Chinese growth continued through the month, and the People’s Bank of China (PBoC) cut its 5-year loan prime rate (LPR) by 25 bps to 3.95%, a move aimed at increasing support for the beleaguered housing and construction sectors. At the margin, this move will lower the total cost of fiscally-supported countercyclical construction, which is supplemented by commercial loans. At the same time, it will likely pressure banks’ net interest margins and the impact on the household sector may prove to be limited. We have already seen a PBoC led industry-wide mortgage repricing in 2023, with muted impact on consumer spending and home sales. Yields on Chinese government bonds continued to fall over the course of February, while Chinese credit spreads tightened.

4) Soft landing and credit. Following the pattern of slowing (but positive) US growth and upside surprises in Europe, credit markets have seen a continued tightening of spreads in February, supported by strong earnings and an improving macro picture. To put this in context, global investment grade spreads are now back at levels seen at the end of 2021, before the hiking cycle began; however, all-in yields remain at levels only last seen in 2009, meaning record issuance by companies could in fact be met by growing allocations to credit funds.

5) Japan. A recurring topic of the last year, the Bank of Japan (BoJ) appears on the verge of ending its 8+ year negative interest rate policy. Inflation slowed for a fifth consecutive month but remains well above target with year-over-year core CPI ending January at 3.5%. The BoJ has been maintaining its ultra-loose policy to establish credibility in generating inflation after the country experienced prolonged periods of low inflation/deflation since the early 90s. The pull down in inflation is coming from lower goods inflation, which points to margin expansion and some pricing power. Higher expected wages coming out of the annual labour union negotiations will likely keep domestic inflation above 2%. All the evidence is there for the Bank of Japan to end negative interest rates at their March or April meetings.