The World Turns: Seeing through the Volatility

The bond market has been full of surprises lately.

China unexpectedly announced its most comprehensive economic stimulus in years. After showing signs of slowing, the US economy bounced back, and inflation dropped to the lowest rate in three years in the United States, Europe, and the United Kingdom.

Some surprises were less welcome. Many government bond yields rose significantly, including the US 10-year Treasury yield, and the US dollar strengthened more than 3%¹—even after the Federal Reserve’s 50 basis point (bp) rate cut last month. Amid these unexpected events and the approach of US elections, volatility in the bond market jumped to its highest level this year.²

China’s Shift

After announcing a broad stimulus package in late September that promised fiscal support, China has followed up with myriad pro-growth announcements and additional policy tweaks—but no details on the fiscal stimulus, leading to much debate in the financial markets over whether the fiscal stimulus will materialize.

Our emerging markets team expects more details to emerge soon, likely at the National People’s Congress meeting in late October. However, what matters more than the details, in the team’s view, is that the central government appears to be making an ongoing commitment. If initial attempts fail to revive the economy, our team expects the government to keep trying. This is crucial because the problems in China’s economy run deep and will likely take time to solve, especially the housing market, where sales have plunged some 80% over the past three years, and households’ aversion to spending.

For the bond market, China’s stimulus could have profound effects. Strong demand for longer-term bonds this year has flattened the yield curve and helped push yields to record lows, including the 10-year China government bond yield at 2.1% (Exhibit 1). Many domestic investors have turned to bonds as a higher-yielding alternative to savings accounts, while foreign investors have flocked to the market this year to take advantage of falling rates and the deflationary environment.

Looking ahead, if the stimulus seems likely to fend off deflation, many foreign investors may retreat, according to our emerging markets team. Already, foreign inflows to China’s bond market have slipped, by the team’s estimates, while inflows to China equity funds soared to almost $40 billion in the first week of October—double the previous record, according to EPFR.³

US: A Sudden Turnabout

At the other end of the growth spectrum, the US economy has been surprisingly resilient—again—adding 100,000 more jobs than expected in September. In response, investors lowered their sights for Fed rate cuts, and Treasury bond yields rose across the board. The benchmark 10-year rate climbed around 60 bps to 4.24%.4

To some extent, yields had fallen too far and too fast before the Fed eased last month, resulting in a bounce back afterward, but there is more to the story. Around half of the increase in the 10-year yield can be traced to a rise in the breakeven inflation rate: In other words, investors’ longer-term inflation expectations rose.

Pulling in the opposite direction and preventing the 10-year yield from straying further above 4%, many investors have been drawn to Treasuries as a “safe haven,” in part due to rising geopolitical risk, especially the widening conflict in the Middle East, according to our US team.

Going forward, the Fed’s clear pivot toward easing, with the goal of normalizing monetary policy, should limit the trading ranges for Treasuries, in the team’s view. Based on market pricing, the Fed is currently expected to reduce rates by 25 bps once or twice before the end of the year and four times in 2025 through May—a view that our team shares.

Buoyed by the US economy’s performance and China’s stimulus announcements, investors had a strong appetite for credit. Investment grade corporate bond spreads tightened some 15 bps to around 85 bps over Treasuries, while high yield corporate spreads fell below 300 bps—a return to historically low levels.5 Our US team saw more value in securitized assets, including mortgage-backed securities.

Europe: Picking Up the Pace

The European Central Bank’s (ECB) latest interest rate cut of 25 bps was its third cut this year but a surprising move in some ways.

The expectation after last month’s central bank meeting was that the next cut would come in December. Since then, however, inflation fell below the bank’s 2% target and was no longer an obstacle to a further rate cut, and the region’s PMI composite fell back below 50, signaling a contraction.

German bunds rose, much as US Treasury yields did—with the 10-year yield bouncing back to 2.32% after falling to almost 2% in late September. It has been a bumpy ride for investors since July, when the yield was 2.6%. Corporate bond spreads tightened, and our European bond team found better value elsewhere: covered bonds in investment grade credit and Nordic bonds in high yield.

Currencies: The Return of US “Exceptionalism”

After underperforming for much of the summer, the US dollar bounced back with the US economy over the past month. With US real rates rising, volatility high, and a tight US election next month, the dollar is likely to stay strong in the short term. Over the medium term, however, our currency specialists expect the US currency to soften as the Fed eases.

So far, the dollar’s strength has affected currencies from G10 countries, notably the euro, more than those from emerging markets. Among developed markets, our team favored sterling; China’s stimulus should also create currency winners elsewhere, particularly in Asia, in the team’s view.

Oil: Too Little or Too Much?

Geopolitical uncertainty was one of the biggest concerns in the oil markets as the Middle East conflict continued to expand over the past month.

Some 20% of global oil supply comes from the region, and our team believes that current oil prices, with the global benchmark Brent crude trading around $75 per barrel, do not reflect the potential risk of supply disruptions.

Holding oil prices down, the story of the oil market outside of geopolitical risk remains one of ample supply—including OPEC’s spare capacity—and weak demand growth, especially in China.

More to Come: A Shifting Landscape

Our fixed income team sees a new landscape emerging for bond investors—one that includes a soft US landing, global central bank easing, and the potential for an awakening in China’s economy. With the US presidential election in November too close to call, more surprises are almost certainly on the way—and will help shape this new landscape.