Back to Business as Usual?

In the calm and collected bond market of late August, there are few signs that a small interest rate increase from the Bank of Japan (BoJ) earlier in the month triggered a week-long sell-off in equities and credit around the world.

Almost as suddenly as it began, the rout ended, and the markets reversed course, recouping their losses for the most part. Perhaps the only visible traces of what transpired: Yen carry trades—in which investors borrow at low rates in yen to invest in higher-rate currencies and assets—declined significantly, and US money-market assets climbed to an all-time high of almost $6.2 trillion, a sign that more money moved into cash.¹

Does that mean “problem solved,” and it’s back to business as usual for the bond market?

Not exactly, as our fixed income team discussed recently. In their view, risks have emerged from the early August whirlwind that will likely shape the remainder of 2024 for investors. These include a higher probability of a hard landing for the US economy and the likelihood of more tightening from the BoJ—even as central banks in much of the world are easing.

US: Preparing for Landing

Relief was in order in the US bond market after the turbulence of early August. US bonds, notably credit, were relatively resilient as the BoJ’s hike of 15 basis points (bps) on 31 July sparked the massive unwinding of the yen carry trade. Bonds also absorbed a weaker-than-expected US employment report immediately after the BoJ’s hike that prompted worries over how quickly US growth may be slowing.

After the selling in risk assets let up, the yield on the benchmark 10-year US Treasury bond floated back toward 4% from its low of 3.67%² as demand for a “safe haven” faded. Investment grade credit, meanwhile, had widened only around 7 bps³—compared with astounding losses of 12% in Japanese equities and 3% in US equities on the worst day of the rout.

After the sell-off, the concern over US growth came to the fore. One of the most striking numbers in the July labor market report was the sharp jump in unemployment to 4.3% from 4.1% the previous month. When that report and some four months of gradually softening economic data are combined, the probability of a hard landing, or recession, for the economy has increased, according to our US analysts.

The economic landing is very relevant for investors around the world. Growing at an annual rate of around 3% over the past year, the US has been a major engine of the global economy while China deals with structural challenges to higher growth and Europe remains below 1%.⁴ Perhaps more to the point, the potential impact on returns could be significant, especially in credit. US high yield bonds, for example, would likely return around 4% more than 1-year Treasuries if the economy lands smoothly, but under a hard landing scenario, they could trail 1-year Treasuries by about 14%.⁵

In our US team’s view, the case for a soft landing remains strong due to:

• fiscal stimulus—with a 6% public sector deficit implying a surplus in the private sector
• the “wealth effect” of rising home values and other gains
• strength in the US services sector, as seen in the ISM Index
• the lack of broad layoffs, based on recent US labor market reports, which can lead to a downward spiral in employment

Disinflation appears to be back on solid footing, with the latest headline Consumer Price Index (CPI) falling to an annual 2.9%. We expect this will clear the way for the Federal Reserve to begin cutting interest rates at its next meeting in September—and Fed Chair Jerome Powell signaled as much in late August at the annual central bankers’ meeting in Jackson Hole, Wyo. In keeping with our US team’s outlook for only a modest growth slowdown, the team currently expects two or three 25-bp cuts before year-end—in contrast to the expectations priced into the markets for more than 100 bps in total.

Emerging Markets: Risk-off

Our emerging markets sovereign bond team brought a different perspective to the hard vs. soft landing debate in the United States.

The US growth slowdown has already driven economic uncertainty to its highest point in some time, in their view. For example, even with US growth currently above 2%, delinquencies on US loans have risen and consumer spending has slowed, based on recent economic data. So if growth continues to fall, those trends will likely accelerate, potentially boosting Treasury bonds and driving down risk assets even without an actual recession. This level of economic uncertainty is not reflected in current bond pricing, in the team’s view.

In addition, emerging markets face a particular risk according to our analysts: High uncertainty has sometimes prompted investors in hard currency emerging markets bonds to return “home” to more familiar markets. As a result, the team has taken a more cautious stance lately. Having sought out attractive yields for much of this year, our portfolio managers have recently favored higher-quality and lower-duration securities, replacing many high-yield and distressed credits with investment grade bonds.

Currencies: Is It Over?

When the selling in risk assets abated earlier this month, the pressing question for most investors was, is it over?

According to our FX Advisory group, the yen carry trade unwinding appears to be done for now. As of mid-August, data from the Commodities Futures Trading Commission (CFTC) indicated that short yen positions had been entirely unwound, and in fact, positions in the currency were net long, our analysts noted.

For investors in risk assets, that should be a relief. However, the story doesn’t end there. After decades of near-zero interest rates and yield curve control, the BoJ is eager to normalize monetary policy, and that in itself bears close watching in the months ahead.

During the early August market turmoil, the BoJ pledged to avoid hiking rates in volatile markets,⁶ but our currency team believes normalizing policy will be an enormous task for Japan regardless of rate-hike timing. Japanese interest rates have been out of step with those in other developed markets for years (Exhibit 1). Japan’s track record for raising rates since its asset bubble burst in the early 1990s is also not encouraging, they pointed out: The BoJ’s rate rises in 2000 and 2007 ignited market volatility around the globe much as the latest one did.

Tightening policy overall will be a challenge because the BoJ holds far more assets on its balance sheet than other central banks do as a result of quantitative easing: the equivalent of 127% of GDP as of March, compared with 27% for the Fed and 45% for the European Central Bank, according to Bloomberg data. It also holds more types of assets, including equities and REITs, which do not mature and “roll off” the balance sheet as bonds do, our currency analysts noted.

The Japanese currency is about 4% weaker against the dollar year to date at around 144, despite the BoJ’s actions this year: raising rates twice, spending some $90 billion or more in the currency markets to support the yen, and announcing a reduction in quantitative easing going forward. While certain metrics would put fair value in the 120 range, our currency team believes that the persistent interest rate differential between Japan and the United States will continue to pressure the yen to stay on the weaker side of fair value.

Credit: Different Perspectives

As corporate bonds withstood the sell-off in early August without serious damage, our credit analysts saw some nuances that may hint at what’s to come.

US High Yield

• Rising concern over the US growth slowdown along with uninspiring second-quarter earnings  may account for some of the 25 bps in spread widening during the early August market sell-off.⁷ While generally positive, earnings for high yield companies have so far fallen short of first-quarter results—and 15% of high yield issuers have even missed earnings estimates. Forward guidance has also been disappointing, with only 10% of companies pointing to more positive earnings for the third quarter—the lowest portion in two years, according to the high yield team.
• Lower-quality bonds—those rated CCC—underperformed higher-quality bonds during the early August turmoil, making for a more pronounced “bifurcation” in the high yield sector, according to our US analysts.
• The combination of a 1% drop in Treasury yields since last October and resilient credit spreads over that time has made all-in yields significantly less attractive, which may be taking the bloom off the rose for some investors, our analysts noted.
• There was good news in the sector: Defaults have been running lower than expected, and US inflows were abundant across the credit market during the sell-off early this month, the high yield team reported.

European Investment Grade

• In Europe, credit still held great appeal, according to our investment-grade team.
• High-quality spreads widened 8 bps in early August8—a big move compared with the daily average of 2 bps, our experts noted—and at the same time, German bund yields actually rose, creating more attractive all-in yields for investors in Europe. In response, inflows have been strong, our credit analysts added.
• The recent return of year-over-year growth in Europe, after four quarters of shrinkage, is a boost for the sector, in the team’s view. Credit fundamentals have improved, with leverage down among BBB and A rated companies and corporate margins finally ticking higher, according to our European analysts.

Change in Routine

The resilience of the credit markets during the sudden global sell-off recently is an encouraging sign as bond investors brace for changes over the next few months.

Investors may welcome some of the changes, including a likely rate cut from the Fed. However, as our fixed income team discussed, there will be many moving parts in the months ahead—from central bank decisions to US elections—which may raise more hurdles to clear.