Bond markets advance on Fed rate cut expectations

Weekly fixed income update highlights

• Treasuries, taxable munis, MBS, high yield corporates, senior loans, CLOs and emerging markets all rallied.
• Municipal bond yields declined. New issue supply was $11.9B, and fund inflows were $2.2B. This week's new issuance is light at $5B.

U.S. Treasury yields were mixed last week as inflation came in hotter than expected while labor market data showed signs of weakness. Spread sectors outperformed similar-duration Treasuries amid the divergent economic signals. We expect the U.S. Federal Reserve to cut rates by 25 basis points at this week's meeting.

Watchlist

• 10-year Treasury yields were close to flat last week.
• Spread sectors universally outperformed similar-duration Treasuries.
• We expect the technical environment for municipal bonds to improve over the remainder of the year.

Investment views

We believe fixed income yields generally present a very attractive entry point, creating compelling income opportunities.

Downside economic risks are material, despite strong fundamentals, with tariffs likely to compress consumer spending and weigh on business fixed investment. But a U.S. recession is not our base case.

Risk premiums may widen further, with entry points likely to become more attractive over the coming quarters. Duration is likely to reassume its role as a growth hedge.

Key risks

• Tariffs further undermine consumer and business confidence, raising prices while weighing on sentiment and activity.
• Inflation fails to continue moderating as expected, weighing on asset prices.
• Geopolitical flare-ups intensify around the world.

Credit markets advance amid Fed cut expectations

U.S. Treasury yields stabilized last week following a substantial rally over the prior month. The 10-year yield declined 1 basis point (bp), though the curve broadly flattened as the 2-year yield rose 5 bps and 30-year yield fell 8 bps. Economic data were mixed as well, with August CPI inflation slightly above expectations. Core goods prices rose 0.35% for the month, accelerating again as tariff impacts slowly work through supply chains to final consumer prices. Meanwhile, initial jobless claims reached a fresh post-Covid high, potentially signaling further labor market weakness, though levels remain historically low. We expect the Fed to cut rates by 25 basis points at this week's meeting.

Investment grade corporates gained again, returning 0.59% for the week and beating similar-duration Treasuries by 25 bps. Spreads tightened toward their recent lows, with the index spread level now at 74 bps. The strong performance came despite somewhat softer technical dynamics. Inflows slowed to $5.9 billion, still a very healthy level, but weaker than the recent pace. Supply was larger than expected with $40 billion of new deals pricing. Those deals continued to be met with strong demand, with average oversubscription rates of 4x as investors jostled to lock-in yields ahead of the Fed's expected rate cut. Separately, preferred securities had another strong week, returning 0.85% and beating similar-duration Treasuries by 62 bps.

High yield corporates also gained, returning 0.27% and outperforming similar-duration Treasuries by 26 bps. Senior loans returned 0.16%. Both asset classes saw healthy supply, with just under $10 billion pricing in high yield and $27 billion in loans. Inflows were mixed, with substantial high yield fund inflows of $1.2 billion, while loan funds had small outflows totaling -$160 million.

Emerging markets advanced, returning 0.48% and outpacing similar-duration Treasuries by 23 bps. Spreads compressed across the board, led by high yield sovereigns which narrowed 11 bps. Inflows were very strong, totaling $1.4 billion, skewed toward hard currency funds. Supply was also active, with almost $16 billion pricing, and those deals were met with robust demand and average oversubscription rates of 4.5x.

Municipal markets rally amid strong investor demand

The municipal bond yield curve rallied strongly last week, with short-term rates declining -11 bps and long-term rates falling -20 bps. New issue supply was well received by investors. Fund flows reached $2.2 billion, including $1.3 billion in exchange-traded fund inflows. This week's light new issue calendar should continue to find strong reception.

The municipal market remains well-supported for several key reasons. First, the government bond market has stabilized. Second, while supply has been elevated this year, demand has picked up considerably in recent weeks, driving the strong rally.

Despite this strength, municipals continue to offer compelling value. Some tax-exempt bonds remain available in the intermediate range at 4%, though inventory is becoming increasingly scarce. Similarly, on the long end, tax-exempt bonds are still offered at 5%, but these opportunities are also growing limited. We expect the municipal bond market to remain well-supported through year-end.

The Chicago Board of Education issued $650 million in unlimited tax general obligation bonds (rated BB+). Strong investor demand prompted underwriters to lower yields at final pricing.

High yield municipal funds captured approximately 50% of the $3 billion in net flows over the last two weeks, marking a remarkable shift after crisis-level underperformance year-to-date. September saw average high yield muni yields decrease -23 bps versus -37 basis points for high quality munis, widening credit spreads by 14 bps. Significant relative value dispersion emerged quickly, with large index constituents leading: Puerto Rico Sales Tax Financing Corporation (COFINA) 5S declined -46 bps, Buckeye 5S fell -42 bps and the Georgia Tollroad deal dropped nearly -80 bps since July.

This week's light muni bond new issue calendar should continue to find strong reception.

In focus: The ECB believes the price is right

As expected, the European Central Bank held its key policy rate at 2% for the second consecutive meeting last week, as President Christine Lagarde stated that inflation "is in a good place."

Unlike the U.S. Federal Reserve, which monitors inflation and the health of the labor market (its dual mandate), the ECB's primary goal is price stability, namely, an inflation rate of 2% over the medium term. On that front, the ECB continues to make progress - inflation has been 2.3% or below since February.

At the same time, growth in the eurozone has been surprisingly resilient. Despite uncertainty over a trade deal between the European Union and U.S., economic activity remained in expansion territory in August for the eighth straight month. Moreover, fiscal stimulus is taking hold while bank credit is flowing. For these reasons, we believe the eurozone economy can strengthen heading into the fourth quarter.

Looking ahead, we don't expect the ECB to reduce rates in the near term unless growth declines rapidly to justify an insurance cut. Instead, the central bank will keep its options open and remain data dependent. That means maintaining hawkish messaging with a dovish safety net, although Lagarde has stated that, when it comes to monetary policy, "I'm neither hawk nor dove. I'm an owl." We also think the euro will strengthen versus the dollar in the fourth quarter as yields on German bunds approach 3% (from around 2.70% on Friday).