Highlights:
- Looking ahead to the second half of 2024, the Fed may not consider a rate cut within the year, given the expected “soft landing” scenario of the US economy, heightening geopolitical tensions and structural inflation, which will result in a higher rate.
- The Fed's neutral rate of interest is expected to enter an upward cycle. If the neutral rate of interest is gradually raised, the urgency of the Fed's rate cuts could be gradually reduced. Investors should take a wait-and-see approach to long-dated bonds as longer-term bond yield could return to the 5% level or above.
- Investors may consider allocating more corporate bonds to their portfolios, especially high investment grade bonds and certificates of deposit. They have low credit risk and are suitable for investors looking for extra yield on top of treasuries.
- In a high interest rate environment, there are still some chances that the credit risk of US and European high yield bonds will increase. From a spread perspective, the attractiveness of European and US high yield bonds is limited. The divergence in the performance of Asian high-yield bonds should continue, with traditional Chinese real estate bonds continuing to face greater liquidity pressure and higher default risk.
- If investors want to seek for higher yields, investors could consider the sectors we are bullish on, including non-AT1 bank bonds, Chinese issuers with more international background, Hong Kong real estate, Japanese high yield bonds, Korean investment-grade bonds and oil bonds.
At the beginning of the year, we mentioned that the interest rate and bond yields will remain elevated for a longer period. The Fed may not consider a rate cut within the year. Looking ahead to the second half of 2024, we maintain our view that the Fed could not consider a rate cut during the year, and the room for rate cuts next year may also be limited, thanks to the factors like expected “soft-landing” scenario of the US economy, heightening geopolitical tensions and structural inflation. The bond yields will remain elevated for a longer period. The long-term bond yields could rebound to over 5% level.
A “Soft-landing” Scenario in the US is Expected
As shown in Chart 1, the US annualized quarterly GDP growth rate for the first quarter was +1.3%, weaker than the expectation of +2.5%, but still in the higher range, especially compared to the rest of the developed economies. Many of them (e.g., the United Kingdom, Germany, Japan, etc.) were in a "technical recession" due to two consecutive quarters of negative GDP growth.
Chart 1: US Annualized Quarterly GDP Growth Rate
On the contrary, the U.S. economy remains resilient due to two factors: (1) strong federal spending and (2) employment remains strong, with robust wage growth. All of them drive the local consumption and economic growth.
(1) Strong federal spending
As shown in Chart 2, the federal current expenditures are still much higher than the level before COVID-19. The current expenditures in the last 12 months were still as high as USD 6.6 trillion, increased by 38% compared to the level before COVID-19 (the end-2019). Approximately 35% of the current expenditures are allocated to healthcare and social security. This not only enhances the consumption of local residents but also increases employment opportunities in the government and generates revenues for the related industries.
Chart 2: US Federal Government Current Expenditures and Budget Deficit
(2) Employment remains Strong, with Robust Wage Growth
As shown in Chart 3, although the local unemployment rate rises slightly, with the latest figure for April standing at 3.9%, it still hovers at a historically low level. It can be regarded as a "full employment" level. The nonfarm payrolls (i.e. change in the number of people employed) remained strong, with an average of increasing 242,000 new jobs per month in the past three months, much higher than the 10-year average before the epidemic, reflecting that the employment situation in the country is still strong.
Chart 3: US Unemployment Rate and the Nonfarm Payrolls
Due to an imbalance of supply and demand in the U.S labour market, corporates offer higher wages to retain talents, leading to a wage surge. As shown in Chart 4, wages are still growing at a rate of 3.9% annually. On one hand, this stimulates local consumption, resulting in monthly retail sales continuing to grow. Besides, it is also one of the factors contributing to the persistently higher inflation rate.
Chart 4: US Wages YoY Growth and Retail Sales
Besides, some residents chose the fixed-rate mortgages during the low interest rate period, and most large corporates issued low coupon, longer-term bonds. These factors mitigate the negative impact from the rate hike. Therefore, we expect a “soft-landing” scenario in the US.
Intensified Geopolitical Situation
The intensified geopolitical situation is also one of the reasons for the higher for longer outlook on inflation and bond yields. Since the Russia-Ukraine war, there are a de-globalization trend worldwide. With some reasons, the relations between Western countries and the China-Russia camp become more strained. Western countries are gradually reducing their dependence on Russian energy and reshaping their supply chains. Many large multinational corporations are relocating their production lines from China to other places to diversify business risks. The Biden administration in the United States is even promoting the long-term goal of re-industrialization. All these factors will increase the production costs for corporates over the medium to long term. This would be passed to the end clients and translate to inflation.
Furthermore, since the beginning of the year, the commodity prices are rising continuously (see Chart 5), including base metals (copper, aluminum) and precious metals (gold, silver). The WTI oil prices still remain at a high level of above $70 per barrel, showing no signs of coming down. This puts significant upward pressure on companies' raw materials and production costs, which serves as another source of inflation.
Chart 5: Bloomberg Commodity Index and WTI Crude Oil Price
It is worth noting that many major commodity-producing countries (such as China, Russia, some South American countries like Brazil, Chile, Peru, Central Asian countries like Kazakhstan, Middle Eastern countries like Iran and African countries like Congo) are not aligned with the Western camp. This lack of alignment might result in lower predictability of the supply growth of these commodities. There is even a possibility that they might form a cartel similar to the Organization of the Petroleum Exporting Countries (OPEC) in the future, attempting to influence commodity prices and increasing the risk of higher commodity prices.
Table 1: The Major Commodity-producing Countries
Gold | Copper | Crude Oil | |||
Producing Countries | As of 2023 Global Production | Producing Countries | As of 2023 Global Production | Producing Countries | As of 2023 Global Production |
China | 12% | Chile | 23% | US | 22% |
Australia | 10% | Peru | 12% | Saudi Arabia | 11% |
Russia | 10% | Congo | 12% | Russia | 11% |
Canada | 7% | China | 8% | Canada | 6% |
US | 6% | US | 5% | China | 5% |
Kazakhstan | 4% | Russia | 4% | Iraq | 4% |
Mexico | 4% | Indonesia | 4% | Brazil | 4% |
Indonesia | 4% | Australia | 4% | United Arab Emirates | 4% |
South Africa | 3% | Zambia | 4% | Iran | 4% |
Uzbekistan | 3% | Mexico | 3% | Kuwait | 3% |
Others | 37% | Others | 21% | Others | 27% |
Total | 100% | Total | 100% | Total | 100% |
Sources: World Gold Council, United States Geological Survey, U.S. Energy Information Administration, iFAST compilations Data as of 31 December 2023 | |||||
Several Structural Factors on Inflation Exist
Currently, the high inflation can be attributed to several structural factors, including the strong consumption demand, wage surges, geopolitical factors, high commodity prices and rents. As shown in Chart 6, there are signs of rebound in Energy and Food CPI, and the annual growth rate of the services CPI, excluding energy services, consistently remain at 5% or higher. The main driver of the increase in the services CPI is the persistently high Shelter index, which tends to more sticky. We believe it is hard to go back to the 2% inflation target for this component.
Chart 6: US CPI Components
Overall, these inflationary factors are not expected to be swiftly resolved through contractionary monetary policies in the short term. Currently, the inflation rates remain far from the Fed’s 2% target. Therefore, it is anticipated that the Fed could not cut the interest rates within the year. There might also be limited room for future interest rate cuts, resulting in higher bond yields.
Potential Upward Cycle about Neutral Rate of Interest
Another factor influencing monetary policies is the Fed’s long-term interest rate target (i.e. neutral rate of interest). The neutral rate of interest represents the level of interest rates which, the policymakers believe, is appropriate in the medium to long term (three years or even longer). It reflects the potential room and pace of interest rate cuts. If the current interest rate level is significantly higher than the neutral rate of interest, the Fed should lower rates until they align with the neutral rate of interest in the medium to long term.
While the natural rate of interest remained at 2.5% for some time, leading the market to believe that this level will be sustained in the long run, the truth is that the neutral interest could be adjusted according to different economic conditions. As shown in Chart 7, after the March and June FOMC meetings, the natural rate of interest increases from 2.5% to 2.75%. This suggests a potential upward cycle. If the neutral rate of interest gradually increases and even surpasses 3%, the urgency for interest rate cuts by the Fed will gradually diminish.
Chart 7: US Policy Rate and long-term Interest Rate Target (Neutral Rate of Interest)
Long-term Bond Yields could Rebound while we are Positive on Short-term Bonds
Currently, the breakeven rate (nominal yields minus real yields) remain below 2.5% (as shown in Chart 8). If the market starts to realize that higher inflation is going to stay for longer period, the breakeven rate will climb rapidly under this narrative change. This drives a rebound on the 10-year treasury yield and return to 5% or above. Investors should adopt a wait-and-see approach towards long-term bonds.
Chart 8: 10-year Treasury Real Yield and Breakeven Rate
Due to the significantly higher duration risk for the long-term bonds and the ongoing yield curve inverted, the short-term bonds are of greater attractiveness. The short-term bonds have a lower duration risk. It is suitable for investors who seek a stable return (as shown in Table 2).
Table 2: US Treasury Yields
Tenor | Yield To Maturity |
6 month | 5.4% |
1 year | 5.1% |
2 year | 4.8% |
3 year | 4.5% |
5 year | 4.3% |
7 year | 4.3% |
10 year | 4.3% |
Source: Bloomberg Finance L.P. Data as of 18 June 2024 | |
Investors can Consider Allocating more Corporate Bonds to Portfolios, especially High Investment-Grade
As shown in Chart 9, the average yield of investment-grade bonds in different markets reaches 5.5% or above, which is significantly higher than the average of the past decade. From an absolute yield perspective, this level of yield is attractive. (The lower yield in European IG bonds is due to the unhedged benchmark index, thus dragged down by the lower yields on EUR bonds)
Chart 9: Global Market Bond Yields
The bond spreads are around 80 to 110 basis points, which is relatively lower compared to the historical level, investors can still consider allocating more corporate bonds to their portfolios, especially high investment-grade bonds and certificates of deposit. These instruments have lower credit risk and are suitable for investors seeking additional yields on top of US treasuries.
As for high-yield bonds, the average cost of issuing USD bonds rises to around 8% (Chinese high yield bonds even higher at 10% or more). This implies that companies need to improve their profitability to offset the burden of interest payments. Therefore, there is still a certain chance of increasing credit risk.
In addition, there is significant divergence in terms of the quality of issuers in the European and US high yield bond markets. Many companies, with a higher credit quality, have a bond yield of only around 6.5%, which is not significantly different from investment-grade bonds. On the other hand, some companies with weak credit metrics could have a bond yield of up to 10% or above, indicating a certain degree of refinancing risk. From the bond spread perspective, these US and European high-yield bonds are also not attractive.
In terms of Asian high-yield bonds, the main composition shifted from Chinese real estate bonds in the past to Indian high-yield bonds at present. There is also a significant presence of Macau gaming industry, Hong Kong companies and Chinese companies in non-real estate industries. The divergence in the performance of Asian high-yield bonds should continue, with traditional Chinese real estate bonds continuing to face greater liquidity pressure and higher default risk. Even though the "517" policy may improve the liquidity of some developers, the Chinese real estate industry still faces significant challenges. It is not suitable for investors aiming for interest income and capital preservation.
Macau gaming companies, Hong Kong property developers and Chinese issuers with international background should have stronger resilience. Most Indian high-yield issuers are in sectors with a higher cyclical nature, such as renewables, financials, coal and mining. Amongst these, the renewables and financials are supported by local policies and have more stable business operations. Therefore, in the Asian high-yield bond market, we believe that the individual bond selection is more important.
As for individual industries, if investors want to seek for higher yields, investors could consider the sectors we are bullish on, including non-AT1 bank bonds, Chinese issuers with more international background, Hong Kong real estate, Japanese high yield bonds, Korean investment-grade bonds and oil bonds.
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Conclusion
Looking ahead to the second half of 2024, the Fed may not consider a rate cut within the year, given the expected “soft landing” scenario of the US economy, heightening geopolitical tensions and structural inflation, which will result in a higher rate.
The Fed's neutral rate of interest is expected to enter an upward cycle. If the neutral rate of interest is gradually raised, the urgency of the Fed's rate cuts could be gradually reduced. Investors should take a wait-and-see approach to long-dated bonds as longer-term bond yield could return to the 5% level or above.
Investors may consider allocating more corporate bonds to their portfolios, especially high investment grade bonds and certificates of deposit. They have low credit risk and are suitable for investors looking for extra yield on top of treasuries.
In a high interest rate environment, there are still some chances that the credit risk of US and European high yield bonds will increase. From a spread perspective, the attractiveness of European and US high yield bonds is limited. The divergence in the performance of Asian high-yield bonds should continue, with traditional Chinese real estate bonds continuing to face greater liquidity pressure and higher default risk.
If investors want to seek for higher yields, investors could consider the sectors we are bullish on, including non-AT1 bank bonds, Chinese issuers with more international background, Hong Kong real estate, Japanese high yield bonds, Korean investment-grade bonds and oil bonds.
Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds T 3.000% 31Jul2024 Govt (USD), T 3.250% 31Aug2024 Govt (USD), T 4.250% 30Sep2024 Govt (USD), T 0.750% 15Nov2024 Govt (USD), T 4.625% 28Feb2025 Govt (USD), T 2.875% 30Apr2025 Govt (USD), T 2.875% 15Jun2025 Govt (USD), T 3.125% 15Aug2025 Govt (USD), T 4.500% 15Nov2025 Govt (USD), T 0.375% 31Jan2026 Govt (USD), T 2.125% 31May2026 Govt (USD), T 2.000% 15Nov2026 Govt (USD), T 1.875% 28Feb2027 Govt (USD), T 2.375% 15May2027 Govt (USD), T 4.125% 30Sep2027 Govt (USD), T 2.250% 15Nov2027 Govt (USD), T 2.750% 15Feb2028 Govt (USD), T 1.250% 30Jun2028 Govt (USD), T 3.125% 15Nov2028 Govt (USD), T 1.875% 28Feb2029 Govt (USD), T 3.250% 30Jun2029 Govt (USD), T 3.875% 30Nov2029 Govt (USD), T 3.500% 31Jan2030 Govt (USD), T 3.75% 31May2030 Govt (USD), T 0.875% 15Nov2030 Govt (USD), T 1.125% 15Feb2031 Govt (USD), T 1.625% 15May2031 Govt (USD), T 1.375% 15Nov2031 Govt (USD), T 2.875% 15May2032 Govt (USD), T 4.125% 15Nov2032 Govt (USD), T 3.375% 15May2033 Govt (USD), T 4.5% 15Nov2033 Govt (USD), T 4.375% 15May2034 Govt (USD) and the analyst who produced this report holds a NIL position in the abovementioned securities.
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