Market commentary bonds: Interest rates on a high and spreads on a low

Second quarter review

Inflation rates in the US and Germany rose slightly in the second quarter of 2024, although it remains to be seen whether this is a short-term effect in the longer-term downward trend or whether inflationary pressure is rising again in the economies.

As can be seen in Figure 1, both the German and US inflation rates are no longer falling. This suggests that the central banks’ inflation target seems not very easy to reach. The German inflation rate recently stood at 2.4% after an interim low of 2.2% in February and March. After reaching 3.1% in January, US inflation is still significantly higher at 3.3%. Only core inflation in the US, which adjusts for volatile food and energy prices, has continued its downward trend and stands at 3.4% after 3.9% in January.

The temporary stabilisation of the inflation rate has led to the first rate cut by the ECB, which lowered the key interest rate by 0.25% to 4.25%. Two further steps for the rest of the year have been categorised by the ECB as “not unrealistic”. The Fed, on the other hand, is still holding back on interest rate cuts and remains cautious in its rhetoric. Most recently, the Fed members’ published interest rate forecasts (“dot plots”) have caused market participants to further increase their interest rate expectations.

According to the latest Fed forecast from June 2024, the median forecast is now only one rate cut for 2024 after three cuts were forecast in March. The forecast for 2025 is now also one rate step higher than three months ago and two steps higher than six months ago. While the ECB followed the Fed in raising interest rates, it is now ahead of the US Federal Reserve in cutting rates.

The interest rate markets remained correspondingly volatile. The Bund yield rose from an initial quarterly level of 2.3% to 2.7% at the end of May but fell back to 2.5% in connection with the ECB interest rate cut and the political uncertainty surrounding the results of the European elections and the new elections in France. In the USA, ten-year interest rates fell from their quarterly high of 4.7% to 4.4%.

Credit spreads have bottomed out after a rally that began in mid-October 2023 and have risen again slightly from there. This applies to all major currency areas and rating classes.

As the chart shows, credit spreads bottomed out in the course of the second quarter and began a countermovement from there. Euro IG spreads recently stood at 1.21% after a low of 1.08%, while USD IG spreads climbed from a low of 0.85% to 0.94%. The picture is similar for global high yield spreads, where spreads have widened by 20 basis points from a low of 3.66% to 3.86%. The rise, particularly in Europe, was triggered by political concerns about France following the European elections. However, a look ahead reveals further concerns.

Outlook for Q3

A look at the mood in the economy continues to show differences between the two sides of the Atlantic. While the manufacturing industry in the USA is expanding slightly, the figures in Europe are still sobering.

While the US index is above the expansion threshold of 50 points, its German counterpart is not only well below it, but also turned sharply downwards again in June. Europe remains caught in the maelstrom of weak growth, high energy costs and the damaging consequences of its own sanctions.

However, there are also a few grey clouds in the economic sky in the USA. Consumer confidence at the University of Michigan has recently fallen significantly again.

Although the labour market, the main argument of economic optimists, remains robust, recent revisions and analyses have shown that there are more problems beneath the surface than are apparent at first glance. For example, the unemployment rate in the US and Europe has gradually risen and is well above the lows of 2022 and 2023.

These economic signals are problematic in view of the massive increase in US consumer debt. A weakening of the US economy is likely to drive up the proportion of non-performing loans significantly. This will affect a banking sector that continues to suffer from hidden burdens in the face of sharply rising interest rates. Many observers suspect that the regional banking crisis in the US could flare up again at any time.

Another risk is the US elections in November. The fear is that the highly polarised country will be unable to come to terms with any outcome. Regardless of the outcome of the election, there is a threat of a further tightening of sanctions, protectionism and sabre-rattling in foreign policy. This is a clear risk for the economy.

Geopolitical risks, particularly in Europe, a weak economy, slowly but steadily rising unemployment rates and the upcoming US elections: In this mix, it seems unlikely that credit spreads will reach their lowest point again or even fall below it in the coming months. Weaker economic prospects should exert upward pressure on spreads, while the political risk premium remains high.

At the same time, any unexpected fall in inflation in this environment is likely to lead to significant decreases in interest rates. In this case, positive returns can be expected from fixed income strategies. The higher the duration of the respective investments, the higher these returns are likely to be.

Outlook 

In view of the risks, interest rate and spread markets have held up very well so far in 2024. However, based on current levels, further upside potential for risk assets after a long rally appears limited for the time being. While increasing volatility is likely in such an environment, investors should remain cautious in their positioning. It seems questionable whether a strategy that focuses exclusively on higher risks represents the optimal positioning over the coming months. Active management with strong selection expertise is likely to become increasingly important. Looking ahead, investors should prioritise these aspects more strongly than ever.