How is the delay in interest rate cuts affecting fixed income?

The delay in cutting interest rates by the major central banks is having an impact on different fixed income products, with an upward shift in the term structure of interest rates and a narrowing of the credit spreads.

The ECB and the Fed are expected to cut their benchmark rates this year. They are in no hurry to do so, as they want to be sure that inflation is slowing enough. In fact, at the beginning of the year, the markets were pricing in up to six rate cuts and now they are discounting just three, more in line with what these central banks were saying in their statements. These will probably not be consecutive cuts and will start in the middle of the year. The difference in economic activity between the US and the eurozone could cause the ECB to move earlier. Meanwhile, in Europe, the Swiss National Bank (SNB) in March already went ahead and reduced its interest rate by -0.25% to 1.5%, thus distancing itself from a potential currency war. The Bank of England, for its part, signalled that it was moving towards easing, as for the first time since September 2021 the vote indicated that no members were in favour of an increase.

The postponement of rate cuts has had an impact on the term structure of interest rates, resulting in a particularly pronounced upward shift at the middle of the curve (2-7 years), with increases of up to 45 bp. The Bund is currently in a stable range between 2.2% and 2.5%. The risk premium of the peripheral countries has notably fallen in the first quarter of the year, benefiting from improved credit ratings (S&P upgraded Portugal from BBB+ to A-) and the significant support of retail investors for Italian government bonds. The 10-2 year spread remains inverted and has been so for nearly 450 days in the US, the longest period since 1976. An indication that monetary policy is tight, awaiting an opportunity for easing.

Corporate and financial bonds continue to enjoy a favourable environment with high liquidity and low volatility in interest rates. Thus, we are seeing a tailwind in fixed income: still attractive yields, decent credit fundamentals, a controlled default rate underpinned by strong demand (more than EUR 300 billion was placed in the primary market in the quarter and absorbed by a high investor appetite with an average bid rate of 4.5x). As a result, credit spreads in both Investment Grade and High Yield are at two-year lows.

In terms of strategy, we prefer Investment Grade bonds, including subordinated bonds from issuers with good fundamentals, rather than High Yield bonds where we recommend caution in the B-CCC space as they face higher funding costs. Sector-wise, we overweight financial, supported by high sector profitability, relative to corporate where we prefer defensive sectors, such as utilities, and see upgrades in the energy and basic materials sectors on better economic growth data and higher commodity prices, if new supply chain frictions emerge, for example. We believe it is important to incorporate active management into portfolios in the face of high complacency, demanding valuations and potentially higher idiosyncratic and geopolitical risk.

_{Date of report: April 10th 2024}