Interest rate cuts yes, but when and how much?

The end-of-the-year rally on the bond markets was driven above all by retreating inflation combined with continued very robust US economy. Most market participants had already set themselves up for a “higher for longer” scenario up to then, in other words for key rates that will remain at the current levels for a longer period of time. But in light of a decline in inflation at a faster rate than had been anticipated by the central banks, the markets shifted to expectations for considerably more rapid and significant rate cuts in the USA and Eurozone.

It is virtually certain that we will see key rate cuts in 2024. But it remains to be seen when they will actually begin, and how rapid they will be. The bond markets priced in very optimistic scenarios in this regard at the end of 2023. Some of this was corrected again during the past weeks. However, there is still a certain degree of potential for disappointment and thus the risk of further price corrections should the central banks cut interest rates later or more slowly than is priced in at the moment. Nevertheless, a great deal is pointing to yields at the end of the year being lower across the curve than they are now. Corporate bonds should again be able to do better than government bonds from the core Eurozone countries.

Investment grade corporate bonds still promising

The investment grade segment, meaning bonds with high ratings, currently appears to have a somewhat better risk/earnings ratio than the high yield segment, where issuers with lower ratings are traded.

The market is currently pricing in an “ideal world”

In addition to falling yields, corporate bonds also profited from narrowing credit spreads versus German Bunds in 2023. This also fuelled part of their outperformance over government bonds from the core Eurozone countries. This yield premium currently averages 135 basis points for euro investment grade corporate bonds versus German government bonds and around 400 basis points for high yield bonds (1 basis point = 0.01%). This means that on market average, around 1.35% more or around 4% more yield is being paid per year than for German government bonds. These credit spreads are pricing in a kind of ideal scenario, i.e. positive but not excessively rapid economic growth, a positive inflation trend, very few defaults, and good refinancing conditions – with only moderate risks to the continuation of these conditions.

Risks: Geopolitics, negative economic and inflation surprises

But it is anything but certain that this good situation will persist. Economic growth and inflation may take a different course as the year progresses, even if the current data provide little indication of this. The geopolitical situation is also more fraught with tension than it has been in many decades, and this offers great potential for sudden, significant price movements.

Credit spreads seem ripe for narrowing

The present risk premiums are also very likely the result of current good liquidity and strong demand from investors. Against this backdrop, the market for euro corporate bonds digested the flood of new issues in the first weeks of the new year unusually well. Normally, such a high supply of fresh bonds from the primary market leads to slight pressure on the prices of previously issued bonds on the secondary market. But this has not been the case yet at all this year. The credit spreads are also reflecting the expectations for extensive interest rate cuts in the near future, with corresponding positive effects on corporate refinancing costs. There is a certain risk of setbacks here, as well, as explained above. (More about bonds and capital markets.)