Bond markets steady as Fed stays on hold
But September or October are in play for a resumption of rate cuts, especially if consumer demand and the job market soften more than expected
SPREAD assets continued to outperform core rates in the year to date, as the US Federal Reserve once again held rates steady at 4.25 to 4.50 per cent. This outcome was in line with market expectations, as was the European Central Bank’s decision to stay on hold.
However, Europe’s central bank was responding to a different economic picture. Euro rates are already in neutral zone; inflation is at target; unemployment is low and economic activity indicators don’t look too bad.
In contrast, US rates remain far from their neutral range as the Fed assesses the impact of the tariffs on inflation and economic activity.
The growth and inflation backdrop supports a patient policy approach. However, dissenting voices in the Federal Open Market Committee (FOMC) seem to be growing in number, and there is mounting pressure from the Trump administration to cut rates.
Going into the next FOMC meeting in mid-September, bond markets are narrowly pricing two more rate cuts by year’s end. Absent a major upside surprise in inflation, we see September or October in play for a resumption of rate cuts, especially if consumer demand and the job market soften more than expected.
From a strategy perspective, we think the current macro and policy environment continues to favour US yield-curve steepening, with the legislative approval of the “One Big Beautiful Bill” underscoring the longer-term fiscal challenges facing the US economy.
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We also think it’s a good idea to build exposure to US Treasury inflation-protected securities at the five- and 10-year part of the curve. Reinflation risks and attacks on the Fed’s independence should not be discounted. Due to these imbalances, for now we maintain a bearish stance on the US dollar.
In emerging markets, we still see local currency opportunities with attractive carry and credible monetary policy trajectories.
We took advantage of the recent US dollar rebound to rotate from short euro to short US dollar as the funding position for our long Turkish lira position. We also extended the bond maturity of our exposure to Egypt, which is looking to improve its macroeconomic scorecard to regain market interest and unlock funding from the International Monetary Fund.
In Asia, we remain overweight in local rates, particularly Indonesia, Malaysia and the Philippines. In Asian credit, we have a slight preference for high yield over investment grade, and are looking to add risk on the back of sentiment-driven sell-off.
Among other spread sectors, US and European corporate credit spreads look tight, but on average, solid company fundamentals, a benign default outlook and high all-in yields continue to make the asset class an attractive source of income.
The primary issue calendar on both sides of the Atlantic has been busy, with deals seeing strong demand. We have participated in several new issues and took the opportunity to rotate out of expensive longer-dated credits.
New issuance is also picking up in European commercial mortgage-backed securities, which can offer attractive spreads with investment-grade risk.
The reporting season began with strong numbers from the US banks, driven primarily by higher trading volumes.
US airlines reported a bounce in premium traffic, though this was not reflected in Europe, where carriers reported weaker numbers and guidance. Airlines are typically good indicators of economic activity, so these trends can be informative about the direction of growth.
Another area of US-European divergence was in the automotive sector; US auto suppliers surprised to the upside while European manufacturers posted weak numbers. We also saw weak guidance from the European chemical sector.
While the next US rate cut looks set to be the most highly anticipated event on the calendar, we think it should not be seen in isolation when thinking about positioning bond portfolios. In many ways, it’s the cross-section of monetary, trade and fiscal policy that matters.
At this stage, fiscal imbalances seem the most predictable, insofar as they are contributing to higher long-term yields. A more complicated question is how monetary and trade policies are influencing short-term rates. Tariffs risk simultaneously lifting inflation and slowing economic activity – a stagflation scenario.
Yet the US trade deals struck with the EU and multiple trading partners in Asia – if they hold up – could help keep stagflation at bay.
That could allow the Fed to resume its rate-cutting cycle, which should benefit both rates and credit markets.
What to watch
- US tariffs: The Trump administration announced a trade deal with the EU, setting tariffs at 15 per cent for EU goods including cars – less than the 30 per cent originally planned. On Aug 1, new tariffs were expected to take effect on other US trading partners that have yet to negotiate deals, such as Canada, Mexico, India and South Korea. The Trump administration has warned that there would be no more extensions, but that deals could be made even after the August deadline.
- Earnings season: The earnings season is only beginning, but the US has already seen more beats than misses, compared with analyst expectations. While the outlook may not be as strong as in January, it is better than the post-Liberation Day gloom that took hold in April. In Europe, it’s a mixed bag so far, with the leisure sector continuing to do well; luxury goods, autos and chemicals are feeling the strain of uncertain tariffs.
- Automotive sector: We have been cautious on the sector for several quarters. On top of the secular challenges of e-mobility and autonomous driving, the industry faces significant short-term risks. The most visible relate to tariffs, but even with accommodative trade deals on the horizon, we observe severe price competition in China, persistent supply-chain instability, and regulatory uncertainty. Most carmakers’ credit metrics started to deteriorate in 2024, and we expect fundamentals to weaken further by year-end.
- Rates outlook: We expect rate-cut expectations to be frequently repriced. Market-implied forward US dollar cash rates are high. We think an allocation to floating-rate notes, alongside fixed-rate corporate bonds, continues to make sense for credit investors looking for “pure” credit exposure – that is, the ability to generate income and total return from security selection and sector allocation without taking interest-rate duration risk. Floating-rate notes exhibit relatively low correlations to other fixed-income assets, and can generate positive total returns, even through rate-cutting cycles.
Michael Krautzberger is CIO of public markets, and Georgios Georgiou is head of fixed-income product specialist, Allianz Global Investors
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