Investors anticipating a continuing rate cut cycle sometimes act like fans filling the stadium all dressed in white for the big home game. Confidence is high and may not reflect the underlying odds. After an up and down first three quarters of the year, as more of President Donald Trump’s policies begin to take effect, key questions emerge: Do rate cuts support additional hiring? Or does that come from confidence in margins and future cash flows? Do lower US Treasury (UST) rates simply lower the cost of capital and encourage even more investment in AI? Or does the broadening-out market support new hires?
We are at a pivotal juncture where decisions made by both corporations and households will help shape the economic narrative heading into year-end. The home team enthusiasm in the UST market has moderated since the Federal Open Market Committee (FOMC) meeting, with a flatter yield curve reflecting concerns about an overly dovish outlook. But as the next quarter begins, investor appetite for US credit remains robust.
Employment and consumption shifting
Consumers, or more precisely, those above average financially, are in the driver’s seat. Personal consumption accounts for 70% of US GDP, and to date, retail sales have been encouraging, with the spring selling and back-to-school seasons both strong. These selling periods are highly correlated with the holiday season – 73% over time – and may bode well for a strong end to the year.
The August sales report showed that the retail control group, which feeds into the GDP calculation and excludes some of the more volatile segments like autos and gasoline, rose by 0.7%. The prior months were revised upward as well. Disclosure: this report is not price adjusted, and could reflect some tariff price increases. However, it still indicates a consumer that is active rather than restrained. Personal spending was also strong in August, increasing 0.6% from July (0.4% adjusted for inflation).
The case can be made, however, that this is a K-shaped recovery, not from a recession, but from the weakness reported earlier in the year, with the wealthier consumer successfully carrying the burden (upper arm) and less-affluent consumers showing signs of stress (lower arm).
An economy that maintains equilibrium, with sound corporate fundamentals and a healthy consumer, typically benefits bond markets.
It’s no secret that older consumers have benefited disproportionately from the strong stock market and housing recoveries since the global financial crisis (GFC) and more recently, Covid. Consumers aged 65 and older are beginning to comprise a greater share of consumption, and while a portion still work, this means that spending is less indexed to work and to labour data. The Boomers are living longer and are wealthier than prior retirement cohorts, with active lifestyles (and spending) providing increased support for economic growth. For example, in my discussions with financial advisors across the country, a common topic is the sharing of wealth by Boomers with younger family members. Many who can, do.
Generational wealth dynamics play out over long periods. But currently, consumer and industrial companies alike are providing positive commentary for the balance of the year. With the passage of the spending bill some further stimulus will emerge in the new year. This, coupled with more settled tariff levels and renewed efforts on deregulation, could broaden the economy, (which plays out in the confidence to hire) and ultimately the markets.
An economy that maintains equilibrium, with sound corporate fundamentals and a healthy consumer, typically benefits bond markets. Yields remain attractive while spreads hold rather than moving sharply wider. This can lead to a steady, and perhaps most importantly, predictable and calculatable return expectation for fixed income. Clipping coupons, in this context, is a good thing, while price appreciation has limits, based on the extent of rate cuts.
Sectors as we enter the autumn turn
Fixed income credit sectors continued to tighten through September with strong demand for yield and the spectre of a Fed easing cycle drawing investors. Treasury yields trended lower as the FOMC meeting approached in mid-September but then partially reversed as the path of easing isn’t as visible as hoped. Taking the underlying credit sectors in turn:
Mortgage-backed securities (MBS): Low volatility and the potential for the US Treasury curve to steepen has drawn incredible demand to MBS and spurred spreads to tighten. While affordability issues persist (prices and high mortgage rates are the culprit), the administration has pledged to take on the issue. Spreads here have tightened markedly in September to less than 30 and are tighter on a year-to-date basis from the close of 42 basis points at year-end 2024. Chatter about a potential public offering of Fannie Mae and Freddie Mac has been persistent, though details are thin and it is likely not a near-term event. Details will matter, specifically on the type of guarantee from the US government.
Asset-backed securities (ABS): Supply has picked up again, but demand has held steady, so spreads continue to grind tighter. The ABS sector withstood some headline pressures as a small ABS issue named Tricolor collapsed and filed for bankruptcy protection. This seems to be an isolated incident as Tricolor’s business focus was subprime auto lending to undocumented immigrants, so the recent immigration policies were detrimental to their business model. While a big headline, the impact on the ABS index was non-existent: spreads are tighter now than earlier in the year. Our process favours traditional ABS segments; the shifts in fiscal policy are creating problems for some of the more esoteric issuance.
Corporate bonds: Spreads of investment-grade securities are at levels last experienced in late 1998. While September is typically a spread widening month on a seasonal basis, this year has defied the trend as strong demand and digestible supply meet to push spreads lower. In turn, while fundamentals are off their strongest levels they are still strong and healthy. Per JPMorgan, revenues are up 4.1% y/y as is EBITDA margin (earnings before interest, taxes, depreciation and amortization) at 32.3% (the highest since Q1 2022). In turn, while interest expense increased a touch, interest coverage dropped a little but still stands at 9.3x. Most strategists are expecting a strong earnings season ahead. Across the rating spectrum, from investment grade down through the rating ranks, deregulation could prompt increased mergers and acquisitions (M&A).
High yield (HY): Spreads are also tighter over the month as yields continue to draw buyers. Our team’s research shows that investors have never been paid less to own risk, with the dispersion among the 25th and 75th percentiles of the ICE US High Yield Index at 143 basis points, which is the tightest relative to quarter-end periods dating back to 1996. In turn, 55% of the index is trading inside 200 basis points. As value-oriented investors, we are cautious, deeming the risk/reward unfavourable.
Emerging markets (EM): This broad and diverse sector has performed well lately, with spreads mostly tighter over the past month. Our seasoned benchmark—bonds issued more than a year previously as represented in the J.P. Morgan Emerging Markets Bond Index – which has more exposure to lower rated EM credits, experienced some spread widening on the heels of Argentina’s election only to snap back following a strong expression of support by US Treasury Secretary Bessent. Our multi-sector team in the US moved to an underweight in EM debt in late August, primarily to take profits as our valuation targets were realized. The bias remains to find a better entry point, as this market provides three distinct ways to express conviction: sovereign debt, corporate issuance and currency local markets are compelling and are our choice over sovereigns. We think the US dollar will continue its descent, but not follow a smooth line, providing opportunities to adjust positioning.
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