The Plot Thickens

For the bond market, a simple narrative about the ups and downs of US inflation—and their possible effects on Federal Reserve interest rate policy—has suddenly developed into a much more complex, global story.

In an action-packed month, the European Central Bank (ECB) cut its policy rate in early June for the first time since 2019—and beat the Fed to the punch—even as growth appeared to be picking up in Europe. Unexpected election outcomes in India, Mexico, and South Africa, as well as a call for snap elections in France, added political uncertainty to the macro picture. And finally, the US economy turned in a puzzling performance: Growth seemed to be slowing, but jobs and wages were still on the rise.

Sifting through the layers at their meeting this month, Lazard’s bond teams observed that currency markets served as a pressure relief valve, though political uncertainty drove bond yields in many countries higher. For some, like South Africa and India, the dust has cleared for now. For others, including Mexico and France, our analysts expected volatility to continue for some time.

US: Strong Convictions

For US bonds, the more complex environment was not a bad thing, and our US fixed income team held fast to many of its convictions.

On balance, the US economy has appeared to soften slightly in the past month or two, which bodes well for bonds overall, our analysts pointed out. Even as employers added 272,000 jobs in May, the unemployment rate rose to 4%, its highest level in more than two years.¹ In addition, the Atlanta Fed’s GDPNow estimate for second-quarter growth sank from more than 4% in early May to around 3% in mid-June.² Consumer sentiment has also drifted down to 69 from its high of 79 in March, based on the University of Michigan survey for May.

These signs of slowing growth supported our US experts’ view that the larger trend of disinflation in the US is likely to continue and lead the Fed to cut rates at least once and possibly twice before the end of the year. Putting the 10-year Treasury yield in a broad “equilibrium” range of 4%–5%, they expected the yield to dip toward 4% in the near term—and in fact, it did drop some 20 basis points (bps) to around 4.25% following lower-than-expected Consumer and Producer Price Index gains in mid-June.³ The team continued to anticipate yield curve steepening as well.

Another strong conviction remained intact for the US team: Agency mortgage-backed securities (MBS) can offer an excellent opportunity for investors. Because US housing market activity has slowed, with fixed-rate mortgages still above 7% and overall affordability near record lows, MBS supply has been relatively low, our US specialists noted. Demand from banks, meanwhile, has picked up since last year and should continue to increase as the regulatory environment becomes clearer and as bank deposits rise on the back of higher-for-longer US rates, they added. So far this year, US banks have added about $40 billion–$50 billion in agency MBS to their securities portfolios, according to the team. In their view, MBS should perform well in the coming months based on this supply-demand imbalance, the attractive relative value of MBS versus other investment-grade asset classes such as US corporates, and the team’s outlook for Fed easing, curve steepening, and corresponding volatility mean-reversion.

In a more contrarian stand, our US analysts have taken a less negative view of the commercial mortgage-backed securities (CMBS) market than the consensus. Although some senior bondholders have lost principal as a result of defaults on CMBS recently—a highly unusual occurrence in that market—there were many “red flags” beforehand, according to our analysts familiar with the transactions. In their view, single-asset single-borrower deals backed by high quality properties in good locations with strong tenants and lease terms are likely to hold up well. Indeed, the CMBS sector is producing not just losers lately, our analysts pointed out, but also winners—the investors who avoided key downside risk factors and therefore have the potential to generate above-market returns.

Election Surprises: Mexico, South Africa, India

In sharp contrast with the US bond market, emerging markets assets were directly in the line of fire following some unexpected election outcomes.

Mexico

What happened: Claudia Sheinbaum’s left-wing Morena party exceeded expectations and won close to 60% of the total vote, giving her a powerful mandate as Mexico’s president. Her party and its allies also secured 74% of seats in the Lower House and fell just three seats short of a super majority in the Senate—a very significant gain because constitutional amendments can potentially be made with a super majority of votes.

What it means for markets: Risk premiums across Mexican assets rose quickly on investors’ concern that with such a strong mandate, Morena could attempt constitutional changes and move toward a more centralized and potentially less market-friendly government, according to our emerging markets experts.

The Mexican peso appeared to bear the brunt of investors’ fears, depreciating 8% against the US dollar immediately after the election, according to our specialists. The peso was the most vulnerable asset in the sell-off, in their view; it was a “star” in the currency market for several years due to strong economic growth in Mexico, the rising trend toward nearshoring of supply chains, and virtually no fiscal slippage by the government. In addition, relatively high policy rates in developed markets, especially the United States, have been exerting pressure on the currency, and with its high carry, the peso was one of the most popular, or crowded, holdings in emerging markets, they noted.

While bond yields were far from immune to the sell-off, they were generally not as susceptible thanks to Mexico’s strong fiscal record, according to our team. Once the new Congress takes office in September and budget discussions begin, what Morena’s strong mandate may mean longer term for the markets could become clearer.

South Africa

What happened: For the first time since the end of apartheid in 1994, the African National Congress (ANC) lost its outright majority, winning 40% of the vote (down from 57% and below our team’s expectations in the mid-to-high 40s). After two weeks of negotiations, President Cyril Ramaphosa entered into a coalition with the second largest party, the center-right Democratic Alliance (DA).

What it means for markets: The biggest source of uncertainty for investors may be how stable a potential coalition can be in a country that has not had genuine coalition politics in 30 years. The rand weakened in the aftermath of the election, according to our emerging markets team. However, the DA party is widely regarded as market-friendly as well as ideologically aligned with Ramaphosa on central issues for the bond markets, including the independence of the central bank and a sustainable fiscal framework, our analysts pointed out. Local bonds and the currency reversed course and rallied when the coalition became official.

South Africa’s bonds offer the highest yields and contribute significantly to duration in the JP Morgan Global Bond Index—Emerging Markets, which makes the election outcome very significant, in the team’s view. While our portfolio managers had positioned portfolios for the likelihood of a “market acceptable” outcome, they had also hedged that view with currency positions.

India

What happened: Narendra Modi was sworn in for his third term as Prime Minister on 8 June, but both he and his Bharatiya Janata Party (BJP) were weakened after the elections left the BJP in need of coalition support to form a government. Two regional parties, the Janata Dal Party and the Telugu Desam Party, agreed to join the coalition. Both are mostly aligned with the BJP’s economic strategy of courting foreign investment, although they differ with the BJP on some important political issues. 

What it means for markets: The shift to a coalition government and the strength of the opposition party in the election made many investors uneasy initially, but the markets rebounded in short order. In the view of our emerging markets bond team the coalition seems fairly well aligned in terms of governance. Assuming the coalition holds, our analysts believe it may avoid tackling controversial reforms upfront and focus initially on sustaining high growth, which has been running at 6.5%–7% lately.

Some political energy will likely be spent on a slight rebalancing of growth toward domestic households and broader, more equitable economic growth in general, according to Lazard’s analysis. While that could reduce headline growth in the short term, our analysts believe it should be better long term for the economy.

A continuation of the overall favorable investment climate would be welcome news for India’s bond market. Starting this month, the country is officially part of the JP Morgan Emerging Markets Bond Index, after a 10-month inclusion process, bringing an estimated $20 billion–$24 billion in foreign inflows to India, our analysts noted.⁴

Europe: Twists and Turns

European Union parliamentary elections in mid-June saw a slight political shift to the right overall—which was widely expected—but within France the far right dominated. That prompted President Emmanuel Macron to dissolve France’s parliament and call for two-stage legislative elections on 30 June and 7 July.

The sudden political uncertainty drove bond spreads wider across the board in Europe, according to our global bond analysts. Regardless of France’s election outcome, they expected politics—and markets—in the country to remain volatile.

The euro area was already dealing with policy uncertainty after the ECB’s 25 bp rate cut on 6 June. Not only did central bank officials forgo providing forward guidance on rates, but also the bank’s own expectations for both growth and inflation in the euro area have increased, our global bond analysts observed. In the team’s view, another rate cut in July was very unlikely, but September was still a possibility if economic data and Fed policy between now and then allow for it.

Central bank easing has heightened the appeal of a few other rate-sensitive markets for our global bond team—notably Sweden and Canada. With core and services inflation falling and currencies holding up relatively well against the strong US dollar, the team expected more rate cuts in both countries. Weak growth has made central bank easing likely soon in New Zealand as well, according to our global fixed income team, although house prices have kept inflation above target.

Developed Markets Currencies: Longer Lives the King?

Lazard’s currency analysts distilled all of these complexities into a strong view: The US dollar is likely to extend its reign over developed markets currencies for the next few months, particularly against the euro.

Why the conviction? First, relatively high US interest rates favor the dollar. Some eight central banks in the G10 look set to start cutting rates over the next four or five months, based on our team’s estimate, but the Fed is waiting for more proof that US inflation is under control before easing. Indeed, the Fed’s new “dot-plot” rate forecast in mid-June showed just one rate cut in 2024.⁵ This sustained rate differential with the US should continue to weigh on other G10 currencies.

Resilient US growth has supported the currency for far longer than many expected. As the chart shows, the US economy has defied predictions and pulled ahead of other developed markets for the past year. Even though economic activity has ticked up outside the United States over the past few quarters, it has not been sufficient to match the pace of US growth. Recently, the expected growth differential between the euro area and the United States for 2024 widened to more than 1.5%.

Also a support for the dollar in the team’s view: Currency volatility and risk premiums, which have been low for some time, are likely to rise as the US elections in November approach. The market should soon begin to digest the uncertainty of the potential outcomes, according to our analysts, and spikes in volatility or risk-off environments have generally tended to favor the US dollar.

Rising Action

The developments of the past month—especially central bank easing and election uncertainty—may have come all at once, but they had long been predicted for this year. Until the past few weeks, however, higher-than-expected US inflation in the first quarter and the Fed’s decisions to hold interest rates steady absorbed much of investors’ attention around the world.

After the slow start, the story of 2024 is getting into full swing, and as the US elections come into focus, the action is expected to rise.