Soft Landing or Hard Truth?

It seems that things are finally falling into place for the bond market.

The Fed has started its much-anticipated easing cycle, the US Treasury yield curve has ended the record-long inversion that began in July 2022, restoring a more “normal” relationship between maturities and yields,¹ US inflation has fallen to a three-year low, and demand for credit has been resilient.

However, there is a catch. As US growth and the labor market slow, the risk of a hard landing for the US economy is weighing on bond investors, even with a Fed easing cycle getting underway. Their growing concern is not without reason: The last four recessions in the US began three-to-six months after a yield curve inversion ended.

Much has changed since the last downturn four years ago, and, as our fixed income team discussed at their monthly meeting, developments in markets and economies since the COVID-19 pandemic suggest that this time could be different.

US: The Elephant in the Room

One of the most profound changes over the past few years is the massive increase in US fiscal spending. This higher fiscal spending is helping to sustain consumer demand, the labor market, and economic growth, according to our US analysts.² It has also driven the fiscal deficit to 7% of GDP,³ a record high outside of recessions and World War II, which creates its own risks, including higher Treasury bond issuance. However, the fiscal support has insulated the country from a recession and made the US economy a bright spot since the pandemic. Its effects may linger: Bloomberg Economic Forecasts as of mid-September showed US growth in 2025 at 1.7%—far short of a recession.

Despite resilient economic growth, the combination of restrictive monetary policy and weakening in the labor market has raised the alarm. Although job growth improved in August from July, payroll numbers for previous months were revised lower. In addition, the rise in the unemployment rate over the past year has triggered the “Sahm rule,” which has accurately identified the early stages of past US recessions.⁴

The Fed seemed to recognize these concerns in opting for a 50 bp rate cut and increasing its estimates for the unemployment rate in an updated Summary of Economic Projections. Notably, the Fed now expects that unemployment this year and in 2025 will rise to 4.4% from its previous estimates of 4.0% and 4.2%, respectively.  

Looking at employment patterns so far, however, our team has seen a gradual deceleration in job growth from very high levels to more normal levels since unemployment bottomed out in April and May 2023 (Exhibit 1). Furthermore, much of the recent rise in the unemployment rate to 4.2% can be traced to workers entering the labor force, which should be less concerning than a rise due to workers losing jobs. This makes the current labor market unique and indicators like the Sahm rule less useful, in our analysts’ view.

Nevertheless, the team is watching two risk factors:

• The labor market is clearly weakening and has not yet shown signs of stabilizing.
• The rate of hiring has been low for some time, and if layoffs rise, the job market may have little room to absorb the newly unemployed—which implies that the unemployment rate could increase more rapidly as a result.
  

The US bond market itself has not offered clarity on the probability of recession, though it has reflected the divergence of opinion. In US credit markets, spreads have remained very tight, implying a low probability of recession, but in the Treasury market, the 10-year yield has fallen about 60 bps over the past two months to 3.70%,⁵ implying rising demand for a “safe haven” and a much higher chance of recession.

In our team’s view, longer-term Treasury yields, including the 10-year, have dropped too far, too quickly. Indeed, they rose after the Fed’s rate-cut announcement, and if the yield curve continues to steepen as our analysts expect, a further rise in long-term yields may contribute to the steepening.

Europe: Too Much Too Soon?

In Europe, yields on government bonds have also fallen too much, according to our team. For example, Denmark’s 10-year yield slipped below 2%, leaving little buffer in the yield curve.

In our team’s view, there has not been a significant change in the outlook over the past two-to-three months to justify the magnitude of the recent decline in yields—a possible sign that the rally may be nearing an end.

Growth has slowed in the region, which opened the way for the European Central Bank (ECB) to cut interest rates by 25 bps on 13 September, a widely expected decrease and the ECB’s second this year. Some ECB officials have recently highlighted the potential for a more pronounced slowdown, especially in core countries such as Germany and France, raising the possibility of a more aggressive easing cycle ahead. Others at the central bank, however, see the recent disinflationary trend abating, which could result in a shallow easing cycle—our team’s base case.

Based on current market pricing, investors in Europe expect another one or two rate cuts from the ECB before year-end.

Emerging Markets: No Ordinary Cycle

Fed easing has typically caused the US dollar to weaken in past cycles, a welcome development for investors in emerging markets currencies and domestic bond markets. The catch for emerging markets, however, is that the post-pandemic business cycle has been far from typical, creating a more uncertain short-term outlook. If US recession fear keeps rising, for example, the US currency could strengthen as investors seek safety. A spike in volatility as the US elections get closer could have a similar effect.

In addition, rather than moving together as one sector, emerging markets have become more idiosyncratic. Brazil may be a prime example. Despite the country’s strong GDP growth, investors have shied away as the Brazilian government has strayed from its fiscal plan, making the country one of the worst performers in emerging markets this year. Meanwhile, the opposite trend—strict fiscal discipline—has drawn investors to southeast Asia, including Indonesia and Thailand, a shift that our analysts expect to continue.

These risks have not dampened their optimism for the year ahead, but the team is approaching the next few months cautiously.

Credit Markets: Seizing the Day

The possibility of a US recession seemed far from the minds of investors in the high-quality credit market.

The lure of relatively high yields kept US investment grade spreads in a tight range of 90–110 bps for most of this year—well below the long-term average, according to our credit analysts. In Europe, investment grade spreads were not quite as strong, but credit demand overall was high enough on both sides of the Atlantic to absorb record new issuance early this month.⁶ On average, new bond deals were covered four times over, our team observed.

Perhaps justifying this resilient demand, fundamentals for investment grade companies have held up or improved lately. Margin recovery during the long landing period for the US economy has driven down net leverage overall, and many companies have allocated capital more cautiously, maintaining their credit ratings despite warnings of possible downgrades from the rating agencies.

Convertibles: All Systems Go?

Recession fears, accompanied by higher volatility and lower interest rates, have boosted convertible bonds, according to our convertibles team.

The structure of convertibles was key to this performance. As fixed income securities, convertibles benefited from falling rates, the small- and mid-cap equities that typically underlie convertibles performed better, and the value of the embedded call option increased with recent volatility, based on the team’s analysis.

With these trends expected to continue in the months ahead, the team’s outlook is bright.

Keeping Watch

Maintaining a close eye on developments over the next several months will be crucial, with Fed easing, US elections, and the softening labor market set to coincide. Although a hard landing is not the base case, the Fed has acknowledged the possibility with its rate cut, and in our view, the risk is far too important to ignore.