Markets send mixed signals
Bond markets delivered two different messages this week. Friday's weak US labour report pulled short-dated Treasury yields lower, while Wednesday's inflation data gave the Federal Reserve (Fed) little reason to rush into raising interest rates.
Longer-term bonds sold off as heavy supply, fiscal concerns and a rising term premium (the extra return investors demand for holding long-term bonds) challenged demand. The result was a wider gap between short- and long-term yields. Markets are becoming less worried about near-term interest rate increases but more cautious about lending to governments for longer periods.
The labour data were the clearest macroeconomic signal. US payrolls unexpectedly fell by 23,000, and previous months were revised lower. The unemployment rate declined, but this was mainly because fewer people participated in the labour force. July core inflation slowed to 2.5% year-on-year, in line with expectations. In our view, the softening labour market limits the case for a hike at the September Fed meeting, which is now heavily priced out by markets.
The European bond market followed the global sell-off, but with an additional energy risk premium. Elevated oil prices and uncertainty around the Strait of Hormuz kept upward pressure on yields. France underperformed as renewed concerns about the country's budget position pushed French government bond yields higher relative to German bonds. Italy and Spain were relatively resilient. This divergence is important: euro government bonds can no longer be treated as one uniform duration allocation, and country selection is becoming a larger source of portfolio risk and return.
Credit markets remained calm. Euro investment-grade spreads tightened slightly and high-yield spreads were broadly unchanged despite the government-bond sell-off. European bond issuance was seasonally light. While tight spreads reduce the margin for error, stable fundamentals and investor demand continue to support high-quality corporate bonds.
From a portfolio perspective, we prefer high-quality corporate bonds over government bonds. Expansionary fiscal policy is increasing sovereign debt in the US and the euro area. This leaves long-dated government bonds exposed to supply and term-premium risks. Corporate fundamentals have improved, reflected in rating trends and leverage ratios.
We favour the belly of the curve (bonds with medium-term maturities) and selective investment-grade credit, while remaining cautious on France. The exception is the AI investment race. We are reluctant to finance hyperscalers and AI infrastructure providers where immense debt-funded capital expenditure is raising both execution and leverage risks.