Resilient demand and price data have pushed global fixed income markets to a point of capitulation. As rate cut expectations are pared back, investors need to watch for potential fault lines.
There is an element of capitulation in the global fixed income markets. The narrative of 2024 being a year of sizeable interest rate cuts, so prevalent just a few months ago, has been upended rather dramatically. A few of months of sticky inflation data and growing evidence of demand resiliency have pushed up yield curves around the world. The markets are not giving up on rate cuts, rather expecting them to take place later and to be fewer.
There is little apparent consternation in financial markets owing to these developments. Public and corporate debt Issuances and refinancing are progressing without a hitch, stock markets are in rally-or-stable mode, volatility markers are at 5-year lows, financial conditions are on the easy side, and currency markets are largely gyration-free.
The key reason for fixed income market repricing causing barely a ripple in wider markets stems from economic data. The inflation surprises so far don’t reveal any supply side distortions or demand shocks. Labour markets in the US are tight, keeping services inflation high, but goods and energy prices are well-behaved, reflecting soft demand in China and ample supply/production.
Even China and Europe, a laggard on the demand side relative to the US, have stopped from yielding negative dataflow. Exports have bottomed out, tourism and travel continue to thrive, and shocks from various wars and inclement weather have been absorbed remarkably well.
As long as high rates are a reflection of strong underlying demand, which in turn reflects higher rate of return on capital, the fixed income market capitulation should be seen in a constructive light. Typically, a higher-than-expected interest rate horizon would bode ill for debt holders, but if their incomes, wages, and profits are growing at the same time, then a higher debt service cost need not be a net negative. There is a delicate balance in place in this context—climbing rates, as long as they are countered by healthy outturns in other items in the balance sheet, can be readily absorbable.
This cannot sustain indefinitely though. Eventually, some parts of the economy will succumb to duration mismatch, balance sheet quality deterioration, or a negative feedback loop from a poorly performing, widely held financial product. Could it be residential mortgages, commercial real estate, or high yield bonds in some other sector? Time will tell, but for now, the ongoing treasury selloff is leaving global markets remarkably unruffled.