Déjà Vu

Based on this pattern, US inflation seems to have become the bond market's outstanding concern—rather than US growth, employment, or recession risk. For investors, understanding what is driving inflation—and what is not—could be key not only to gaining insight on the Fed's likely course on rates but also to staying focused on an otherwise attractive market for yield, according to our fixed income professionals.

To that end, when our bond teams met in mid-March, they looked behind the latest inflation numbers with the help of Lazard's solutions team.

US Inflation: The Devil in the Details

Our team first put recent developments in the outlook for US inflation in perspective.

Global inflation pressures eased tremendously in 2022, as they explained, with supply chain disruptions abating and commodity prices declining from high levels. This passed through to headline inflation first and then to core inflation (inflation excluding volatile food and energy prices) with a lag. For the median country in the MSCI World Index, year-on-year headline Consumer Price Index (CPI) inflation peaked at 8.4% in October 2022, and core CPI inflation at 6.6% in March 2023, falling rapidly in the second half of 2023. Year-on-year core CPI inflation for the median MSCI World Country stood at 3.5% in January 2024—roughly two-thirds of the way back to central banks' targets.

Progress in the United States was even more rapid during this period. The monthly pace of the core Personal Consumption Expenditure (PCE) inflation (the measure preferred by the Fed) was near or below target for six of the final seven months of the year.

More recently, however, inflation's descent has wavered. Monthly core PCE inflation in January 2024 was its highest since January 2023 and more than double its pace in the second half of 2023. A stronger-than-expected February 2024 CPI suggests that February core PCE inflation (due to be released at the end of March) will likely remain elevated, even though it will likely slow, raising significant questions about whether inflation is proving stickier than hoped in the “last mile.”

Our teams believe that the recent upticks have raised uncertainty about the outlook, but that they could just be a “speed bump” in the overall disinflation trend. Dividing the core basket into three major components, they looked at trends on a monthly basis:

• Core goods were in outright deflation in the second half of 2023. The general expectation has been that deflation in this category would moderate over time but could continue for awhile given still-elevated price levels. In February, this category was a positive contributor to inflation, but that likely represents volatility in the data rather than a new trend, in their view.

• Housing inflation remains elevated and has only gradually come down. However, more disinflation is expected in this category because CPI and PCE measures tend to lag measures of “new leases” by a year, and these have declined. In January, monthly housing inflation rose due to a strange discrepancy between measures for tenant-occupied and owner-occupied housing. This discrepancy was resolved in February, and while uncertainty about the outlook has eased, there remain some questions about why housing inflation has plateaued in recent months.

• Non-housing core services inflation also remains elevated and has only gradually come down. The outlook for this category is somewhat ambiguous, because it includes a variety of services, among them healthcare, transportation, education, and hospitality. However, it is thought to reflect labor costs and is expected to decline based on slowing wage growth. On a monthly basis, it increased significantly in January, with many analysts believing the surge reflected seasonal effects from beginning-of-the-year adjustments to prices and wages. The category remained elevated in February but was not as “hot.” Moreover, the drivers of the category shifted, from “sticky” components in January, to more volatile ones in February, lending additional support to the theory that the recent uptick may be temporary.

As our team discussed at this month's meeting, delving into these details can provide insights not just on the likely path for inflation, but also on the Fed's likely course. January and February inflation releases have contributed to a significant swing in market pricing of the likely path for the fed funds rate, which implied as many as six or seven 2024 rate cuts late last year but suggest just three as of mid-March.

US: Smooth-ish Sailing

Perhaps not surprisingly in light of recent inflation reports, US inflation expectations have drifted higher over the past few weeks, with a pronounced rise in the two-year breakeven rate to roughly 2.8% from 2%, and a smaller rise in the 10-year rate to around 2.3% from 2.1%, based on Bloomberg data.

Aside from inflation worries, though, our US bond team reported a generally “benign” market environment. Volatility, as measured by the ICE BofA MOVE Index,² has dropped so far this year. The benchmark 10-year US Treasury yield jumped to around 4.30% from 4.10% in the days after higher-than-expected inflation was reported,³ but, as a US analyst pointed out, that level is still well below the 5% reached in October 2023.

Of note, demand for tax-exempt municipal bonds has continued so far this year. As a result, despite healthy issuance, munis with maturities of 10 years or less have become more expensive than comparable Treasury bonds on a tax-adjusted basis—an unusual turnabout, according to our US specialists. Conversely, they noted, taxable muni bonds have been much more attractively priced but hard to find.

Sharing the spotlight in the muni market was a lawsuit brought by investors that essentially challenges the University of California's interpretation of the “extraordinary redemption provision” in Build America Bonds (BABs). The university has been planning to redeem its older taxable BABs under this provision and complete a $1.09 billion refunding at lower rates in the tax-exempt market.⁴ Uncertainty around the outcome of the case pushed BAB California spreads wider versus non-BAB California issues, our team observed.

US High Yield: Off to the Races

Investors seeking market excitement over the past month might have found it in US high yield. Bonds in the CCC segment have returned almost 3% so far this year, compared with less than 1% in high yield overall, based on ICE BofA high yield indices in mid-March.

The outperformance reflects a general “risk-on” attitude, according to our specialists, who noted that the US equity markets were setting new record highs at the same time. The enthusiasm may ultimately stem from better-than-expected corporate earnings, they added: Some 80% of companies beat or met expectations for the fourth quarter, and 60% had positive or at least neutral outlooks and guidance.

Our high yield experts did not share the market's enthusiasm for CCC credits, however. One reason was that in the higher interest rate environment, some stressed companies in the lower credit tiers have not been able to refinance their debt despite an otherwise receptive high yield market, according to the team. Also, the pace of credit rating upgrades has recently slowed, our analysts pointed out, though corporate defaults were generally expected to remain very low at 3% or less this year.

Taking a more cautious approach, our team was focused on better quality companies and idiosyncratic opportunities for attractive yield, generally avoiding broad overweight allocations to sectors with heavy competition for “shrinking pies” of business, like media, and high capex needs, like paper and packaging.

Emerging Markets: The Trend Is Your Friend

“Risk-on” was also apparent in emerging markets bonds, where even distressed sovereigns have been able to issue new bonds over the past month. Argentina, El Salvador, Ghana, Suriname, and Turkey, to name a few, have successfully accessed the bond market, all bolstered by recent improvements in policy, according to our specialists.

For sovereigns in general, the macroeconomic picture was good and improving, they added, and credit rating upgrades are projected to come faster than downgrades in 2024; several countries, including Azerbaijan, Cote d’Ivoire, and Oman, are seen as increasingly likely upgrade candidates. For companies, bottom-up fundamentals have been strong overall—with low net leverage—defaults have been few, and bond supply is plentiful, creating one of the best starting points for investors in years, according to our emerging markets team.

The one area of possible concern lately is high valuations, in their view. Though still discounted to developed markets, high yield emerging markets bonds in particular have become less attractive to our portfolio managers due to the combination of tight spreads and lack of clarity on the Fed's plan for US rates.

European Banks: A Happier-than-Expected Anniversary

Rounding out the overall positive picture for bonds in recent weeks, European banks emerged resilient on the one-year anniversary of the US regional banking crisis in early March.

During the first nine months of 2023, European banks reported their best three quarters since 2007, with a return on tangible equity (ROTE) of 14%, according to figures from our banking team. And for many banks, our analysts noted that last year was the best on record.

That is a surprise ending, our analysts noted. The collapse of Silicon Valley Bank (SVB) 12 months ago, which stemmed from losses on its investment portfolio as interest rates rose, had triggered concerns over the health of financial institutions around the world, leading eventually to the takeover of Credit Suisse by UBS at the end of March 2023.

Despite this profound impact on the sector, European banks have emerged stronger over the past year, thanks in large part to higher revenues from rising interest rates, our bank analysts explained. Net interest income grew by 22%–29% in Europe and represented approximately two-thirds of bank revenues in 2023, by our team's estimate. With all the positive developments, credit rating upgrades in the sector exceeded downgrades at a rate of around six to one last year, our team observed.

Looking ahead to the rest of 2024, the banking team expected that revenue growth from higher rates would flatten. Nevertheless, high employment in Europe along with recent wage increases bode well for consumer loan performance, in the team's view, and capital levels appeared more than adequate to cover potential losses on commercial real estate loans.

In the finishing touch for European banks, the market for bank capital securities known as Additional Tier-1 (AT₁) bonds has bounced back after the cancellation of Credit Suisse's AT₁ bonds in the UBS merger last year. In fact, AT₁s have thrived, beating other subordinated and senior bank debt with a return of 12.9% since the end of March 2023, according to our analysts.

Staying Focused

The glass has often seemed half-full in the bond market over the past month, with long periods of equilibrium in US Treasuries and a serious risk-on stance in emerging markets debt. If US inflation remains “sticky” in the months ahead and affects the Fed's plan to ease, that view could change.

This leg of the journey to the Fed's 2% inflation target is proving bumpy, but Lazard's fixed income professionals have stayed focused on the overall downward trend in inflation and the likelihood of Fed rate cuts, which, in their view, remain unchanged.