Fast reading
- The Fed is expected to start easing policy in June or July and many investors expect the BoE will also cut rates in the summer. The latest UK inflation data showed prices falling more than forecast to 3.4% in February. The ECB is also expected to start easing policy in June.
- A rally in Italian government bonds has narrowed the spread – the gap between 10-year borrowing costs in Italy and Germany – to the lowest level in more than two years, as investors become increasingly optimistic about the prospects for Italy’s economy, while growth in Germany has stalled.
The US Federal Reserve and the Bank of England (BoE) both kept rates on hold in their meetings this week, but amid an improving economic outlook, both central banks signalled they are edging closer to cuts.
The Federal Open Market Committee voted on Wednesday to maintain rates at a two-decade high of 5.25-5.5%. However, officials indicated they still expect around 75bps of cuts this year.
“The Fed believes inflation is on a sustainable, if bumpy, path back to its 2% target, and it needs additional confidence from the data before moving to a less restrictive policy,” says Susan Hill, Head of Government Liquidity Group at Federated Hermes. US inflation stood at 3.2% in February.
“Fed Chair Jerome Powell’s communications were consistent with our outlook for easing by the Federal Reserve starting in June or July,” Hill adds.
The clear and consistent messaging from Fed Chair Jerome Powell is fuelling market exuberance
Equity markets rallied on the expectation of rate cuts in the summer. The blue-chip S&P 500 Index closed up 0.9% on Wednesday, to hit a new record high, continuing a rally that has driven the index up more than 10% this year. Hong Kong’s benchmark Hang Seng index closed up 1.9%1.
“The clear and consistent messaging from Chair Powell is fuelling market exuberance,” says Lewis Grant, Senior Portfolio Manager for Global Equities at Federated Hermes Limited. “However, while the bulls are in charge and have focussed only on the positives, we note the subtle tweak in Fed expectations towards a slower reduction in inflation. We are not out of the woods yet.”
The Bank of England, meanwhile, held interest rates at 5.25% at its meeting on Thursday. The latest UK inflation data realised this week showed prices falling more than forecast to 3.4% in February, which has added to expectations that the central bank will also begin cutting rates over the summer. BoE Governor Andrew Bailey said “things are moving in the right direction” for future policy easing.
The blue-chip FTSE 100 closed up 1.9% on Thursday, while the pan-European Stoxx Europe 50 was up 1%2.
Figure 1: Falling UK inflation
Credit market flows
The expectation that central banks will cut rates this year has buoyed debt markets. The yield on the two-year UK Gilt had dipped to 4.1% at 16:30 GMT on Thursday, while the two-year US Treasury yield stood at 4.6%3.
“This year we’ve seen strong flows into credit markets, » says Nachu Chockalingam, Senior Portfolio Manager for Fixed Income at Federated Hermes Limited. « Inflows have come from many different areas, but mainly from cash and money market funds into credit as people worry about reinvestment risk, especially when they’re invested in short duration assets and given that we are at peak rates.”
Elsewhere, a rally in Italian government bonds has narrowed the 10-year spread4 to the lowest level in more than two years, as investors become increasingly optimistic about the prospects for Italy’s economy, while growth in Germany has stalled.
“Euro spreads have had a strong start to 2024 and are almost back at the levels of the post-Global Financial Crisis era,” says Orla Garvey, Senior Portfolio Manager for Fixed Income at Federated Hermes Limited.
“This is mainly due to the generally more positive environment for credit spreads but also the fact that peripheral countries have been outperforming core countries in growth terms. Strength in exports, such as tourism and goods, and ongoing fiscal programmes have allowed Italy to decouple from Germany and potentially boosted the future outlook. Moody’s recently upgraded the outlook for Italian banks while downgrading its outlook for financials in other eurozone countries.”
Figure 2: Italy’s falling risk premium
“Although Italian government bond spreads have tightened significantly, the environment seems supportive. The political outlook is stable, and growth should continue to outperform core. The ratings momentum is also positive,” Garvey adds.
“We expect that the European Central Bank (ECB) will start to ease policy in June, which should also be supportive at the margin level. Italy still has the structural drag of a poor demographic profile and high public debt, but these longer-term issues are outweighed at the moment.”
For further insights on fixed income, please see our latest video on Unconstrained Credit.
Share:
1 Bloomberg as at 21 March.
2 Ibid.
3 Ibid.
4 The difference in yield between 10-year government bonds issued by Italy and by Germany.
