Le risque est plus important que les liquidités

Back to rate cut bets 

May’s strong market performance owes much to recent changes in interest rate expectations. Gone are the fears of US rate hikes. Indeed, the soft landing scenario for the US economy is as likely as ever. Year-on-year inflation rates for both headline and core consumer prices eased a little further in April. Retail sales were soft and the employment report was weaker than in recent months. In April the unemployment rate edged up to 3.9% (it had been 3.4% a year earlier). Bloomberg TV has dedicated much airtime to the weakness in consumer confidence indicators (a very disproportionate relationship between time spent discussing and the usefulness of that economic statistic).

In Europe, the inflation picture is also encouraging. Most countries reported stable or lower inflation rates in April. In the UK, because of lower energy prices compared to the last two years, April’s headline rate is expected to be much lower than March’s. Fixed income markets have loved the re-emergence of the rate cut story.

Flaming June 

Central banker messaging has also been helpful. US Federal Reserve (Fed) officials have dismissed the need for higher rates. Meanwhile European Central Bank (ECB) policymakers have steered markets to expect a rate cut in June. The Bank of England (BoE) has been less explicit but recent comments from Governor Andrew Bailey are consistent with the Bank also starting to cut rates next month. Markets are now pricing in two Fed cuts, and slightly more than two cuts from both the ECB and BoE before the end of the year.

This Goldilocks outlook is positive for markets. I doubt the backdrop will always seem as benign as it has in recent weeks but for now the risk rally looks set to continue to the benefit from credit and equity investors. Rates to ease, growth modest but positive and inflation generally moving lower.

Yield can equal return 

For fixed income investors, the current outlook is beneficial to a broad exposure to credit, including high yield. Credit spreads may be towards the tightest levels of recent years but the total yield for credit strategies is attractive. The last time US investment grade credit spreads were as tight as they are today was in the middle of 2021. Back then, the overall index yield was just 1.9% compared to 5.4% today. It’s the same story in the euro and sterling credit markets. As I have pointed out many times before, the initial yield on a credit portfolio with a duration of ‘X’ years is likely to be very close to the total annualised return so long as the holding period is also close to ‘X’ years.

Curves to move, but slowly 

The duration call from here is interesting. Rates are at their peak and the risk of additional rate hikes has disappeared for now. That should mean long-term rates (10-year government bond yields) are not likely to move materially higher than the range in which they have been trading this year. Thus, a long-duration stance is less risky today than it has been. This is reflected in short-term performance with long dated US Treasuries being the strongest performing fixed income asset this month.

However, long-term yields are unlikely to move materially lower either. Inflation remains above target and monetary easing will come slowly. Yield curves are still inverted and the shift towards flatter – and eventually positively sloped - curves will be driven by short-term yields coming down. In the pure rates space, short duration strategies have consistently outperformed longer duration strategies in both rising and falling interest rate environments. I looked at the relative performance of one-to-three-year and seven-to-10-year indices in US, German and UK government bond markets. The shorter duration bucket has been the better performer over the last 10 years. If yields on the shorter bucket fall to match yields on the longer bucket, returns from the short duration bucket should be stronger again (assuming long-term yields don’t move much).

Credit just looks good 

Looking at those same maturity buckets in credit markets provides a slightly different story. Over the last decade in the US, longer duration credit has outperformed short duration credit. Unlike the Treasury market, the credit curve has tended to be positively sloped most of the time, so longer duration returns benefit from higher yield (carry). In euro and sterling markets, shorter duration credit strategies outperformed over three-and-five-year horizons but not over the full 10 years, nor over the last 12 months.

Bonds vs. cash

The case for short duration credit strategies is strongest when compared to cash. Interest rates on cash have peaked and will decline over the next year. When rates are cut, remuneration on cash declines but bond prices rise. So, a short duration credit strategy benefits from having, today, the same yield as overnight cash rates but also the potential for capital gains when rates are cut and, perhaps, from the further modest tightening of credit spreads.

Volatility is low, liquidity is strong…no-one is selling 

I can understand investors that remain with large cash balances being frustrated by having missed a strong equity market rally and having seen credit spreads tighten. At the same time, there are convincing cyclical and secular reasons for investing today or staying invested. Another rate shock has a low probability. The macro backdrop in developed economies is benign. Commodity markets are calm. Equity markets, while making new highs in terms of price, are close to their average valuation levels over the last three years (measured by forward price-to-earnings ratios). It may all be too good to be true, but volatility is low, so it’s cheap to hedge risk exposure – the VIX is at a five-month low, and the crossover credit default swap is at its lowest level since the beginning of 2022. It’s turning out to be a reasonable year.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 16 May 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.