Can the Bond Market Keep Its Cool?

Calm, cool, and collected might describe the fixed income markets of early 2024. After the spike in bond yields last October and the stunning two-month rally that followed, moves in the bond markets seemed far more measured, and government bond yields appeared to be approaching an equilibrium.

But the specter of higher US inflation broke the calm in mid-February. The headline US Consumer Price Index (CPI) for January, which was widely expected to drop below 3%, rose 3.1% from a year earlier, with core CPI at 3.9%.¹ In response, the benchmark US 10-year Treasury yield jumped 16 basis points (bps) in a day to 4.33%,² and many investors pushed back their predictions for the start of interest rate cuts from the Federal Reserve to June or July.

The CPI report may end up being just another “bump” on the long journey to the Fed’s target inflation rate of 2%, but it clearly struck a nerve with investors. One reason may be that US growth has rebounded sharply since the beginning of the year—to 2.9% from 1.9%, based on the Atlanta Fed’s GDPNow tracker. Accordingly, the 10-year Treasury yield had quietly ticked 30 bps higher this year before the January CPI report.

Will the US economy continue to run hot, possibly reigniting inflation? And if so, could US inflation come bounding back as it did during the 1980s, requiring actual rate hikes from the Fed, or would it be more likely to simply hold steady as it did during the mid-1990s and lead the Fed to keep rates “higher for longer?”

At their meeting in mid-February, Lazard’s fixed income professionals tackled these issues and discussed how they were managing US, emerging markets, and global bond portfolios as US growth re-accelerated.

US: FOMO Rules

Easier financial conditions and ongoing fiscal stimulus—now coming from the bipartisan Infrastructure Act and the Inflation Reduction Act rather than pandemic-related support—have helped bolster US growth expectations so far this year, according to our US bond team.

The slow rise in US Treasury rates over January and February, which reversed some of the gains from the fourth-quarter rally, seems to have strengthened demand for bonds. According to our US specialists, almost insatiable demand absorbed a deluge of new government and credit issuance without a dramatic rise in yields. As one portfolio manager explained, many investors seemed to fear “missing out” on what could be the highest yields for years to come if the Fed begins to ease in mid-2024, as the market currently expects.

The gradual grind higher in Treasury yields has also contrasted sharply with the record-setting rallies in US stock markets so far this year. According to our analysts, this new detachment between bonds and equities could signal a return to lower correlations between the asset classes, which would be a welcome development for investors seeking diversification from fixed income.³

Credit in general was too expensive to attract much attention from our team, and our US portfolios overall remained very underweighted to the sector. Lazard’s bond managers continued to focus more on yield curve positioning than rates; the length of time the yield curve has remained inverted combined with the recent Fed pivot have strengthened their conviction that the curve will return to normal—an upward slope with long-term rates higher than short-term rates.

They were watching inflation closely but were not overly concerned about the near term. In their view, a second wave of inflation could form later this year or in early 2025, if growth remains strong, and put upward pressure on long-term rates.

Local Currency Emerging Markets: Marching to Their Own Drum(s)

While keeping an eye on US growth and its impact on Fed policy, our local currency emerging markets team was far more focused on the central banks within its regions.

The broad narrative on emerging markets for some time has been that many central banks are poised to cut rates (and some have started) after fighting inflation with aggressive rate hikes. To our specialists, however, the story is far more nuanced by region and country—creating opportunities for investors in the dispersion.

The team has divided local markets into three brackets.

1. Low growth and low inflation economies, including Chile, Peru, Czechia (Czech Republic), and Hungary. With core inflation running at 2%–4%, central banks have the option of easing aggressively and taking policy rates below neutral to stimulate growth.
2. High real yield and sticky service-inflation economies, including Brazil, Mexico, Poland, and Romania. Central banks here aim to normalize real rates rather than stimulate their economies.
3. No inflation and weak growth economies, encompassing much of emerging Asia, including Thailand and China, and representing the greatest investment challenge, in our team’s view.

Currency positioning has been one way for the emerging markets debt team to take advantage of the dispersion among these brackets. Our specialists expressed caution about taking short positions in the US dollar for the next several months before the Fed eases, however. They also debated the likely path of the Chinese renminbi in light of the ongoing real estate crisis in China, on one hand, and the potential they saw for at least a temporary economic rebound, on the other hand.

Currency moves overall in emerging markets have become more idiosyncratic over the past several years, according to our experts. They recently compared currency moves in the decade before the COVID-19 pandemic through 2019 with those of the past four years and found that emerging markets currencies used to be more correlated to global factors—and thus more correlated to each other. But in recent years, each country’s terms-of-trade and current account have become stronger drivers, a trend that our team expects to continue, creating more dispersion in currency performance—and potential opportunities for investors.

Global Bonds: Will the US Prove Exceptional—Again?

Bond investors in developed markets, particularly in Europe, were far more concerned than those in emerging markets by the uptick in US growth.

According to our global fixed income team, the growth surge has revived the risk of “US exceptionalism.” If growth is significantly stronger in the United States than in other developed markets—a serious possibility now that the European Union has lowered its 2024 growth forecast and the United Kingdom and Japan have officially entered recession⁴—the Fed could keep rates higher for longer, thereby limiting the ability of other central banks to ease without putting pressure on their currencies and investment flows. As a result, policy outside the United States could remain relatively tight, keeping growth weak. Concern over US exceptionalism increased in early to mid-2023 but subsided later in the year as disinflation took hold and the Fed’s rate-hike cycle ended.

Despite this risk and the EU’s projection for slower growth, the macro picture in Europe was improving modestly for some—notably France, northern Europe, and the peripheral countries, according to our analysts. However, measures of Germany’s economy have softened, aside from the labor market, they added.

Demand in Europe’s bond markets has been strong enough to absorb the high volume of new bonds so far in 2024, an encouraging sign to our global bond team. With the possibility that disinflation is slowing, our global portfolio managers took some profits on richer corporate bonds, replacing them with covered bonds as a way to increase quality without giving up much yield. Inflation-linked bonds also offered attractive real yields, in their view—as well as a hedge against a potential resurgence in inflation.

Global Credit: Walking a Tightrope

Credit markets were a balancing act for the global bond team: Company fundamentals seemed to be improving overall, but investors were paying up for it.

Indeed, credit spreads in certain markets, such as the United States, were near their tightest levels of the past decade, surpassed only by a period during the pandemic in 2021. Demand was so buoyant that some new corporate bonds were heavily oversubscribed—even up to 10 times, our analysts noted.

Fundamentals for European companies, notably leverage, have improved since the third quarter of 2023, in the global credit team’s view, though fourth-quarter earnings reports were mixed and companies have been counting on rate cuts from the European Central Bank, which have yet to materialize. Of note, European bank bonds—especially those of German lenders, including PBB and some Landesbanks—came under heavy pressure in early February after New York Community Bancorp reported higher provisions for expected losses on its commercial real estate loans. Larger banks in Europe should weather the storm well, according to our analysts, but smaller regional banks could be more vulnerable to any real estate “contagion” and bear watching.

Record-high new issuance in US dollar-denominated credit also met with strong demand and few concessions on yields, according to our global specialists. Based on fourth-quarter earnings reports, fundamentals appeared to have troughed and started to rebound in early 2024, with leverage ratios already improving; also, as growth has accelerated, the probability of a US recession in 2024 has been receding.

The Resilience Riddle

Warding off a recession this year is one potential outcome of the recent growth rebound in the United States, as our fixed income professionals discussed at this month’s meeting. If growth holds up, a resurgence in inflation is likely later this year, along with fewer Fed rate cuts than the market currently expects, in their view.

Yet, why the US economy has been so resilient in 2024—and for the past few years—is still an open question. US fiscal programs have helped, as our portfolio managers pointed out, but there may also be structural changes underway that are harder to detect.

As technology advances, for example, is the US economy at last entering a period of higher productivity and higher growth? With potentially huge ramifications for US assets and Fed policy, this is a question our fixed income professionals will continue to consider.