By Ashok Bhatia, CIO and global head of fixed income at Neuberger
The pattern feels familiar enough to repeat. Yet, this time is different, at least for the US, with a more complex and contested monetary policy outlook in other developed markets.
In 2022, unemployment was falling, post-Covid fiscal stimulus was extensive and financial conditions were loosening. Today, each of those variables has reversed, changing the case for how central banks should, and likely will, respond.
Last week’s decisions by the Federal Reserve, the European Central Bank (ECB), the Bank of England (BoE) and the Bank of Canada (BoC) to hold rates steady reflects this tension. The uniform action and hawkish tone across all four central banks might suggest alignment, but beneath the surface, a more nuanced and growing divergence among them is taking shape.
Elevated oil prices present more of a growth than an inflation risk to the US and that with the macro backdrop so fundamentally different from four years ago, the basis for an easing bias remains firmly in play.
The Fed’s stronger case for easing
As expected, the Fed held rates steady at 3.50 – 3.75%, but acknowledged that ‘the implications of developments in the Middle East for the US economy are uncertain,’ simultaneously elevating risks to both sides of its dual mandate.
The meeting concluded with a hawkish tone across the economic projections and press conference, with interest rates shifting up across the curve as the market priced out the possibility of a Fed cut this year. Average market pricing has shifted from more than two cuts before the conflict to pricing a slight probability of a hike in 2026.
While we are conscious of the inflationary impact of the conflict, we see the repricing as an overcorrection. Our base case is that the Federal Open Market Committee remains in an easing cycle and will deliver an additional two to four rate cuts, taking policy rates to 2.75 – 3.25%, on the back of a weakening labour market and a more dovish Kevin Warsh-led committee.
Supporting this is the US has just printed a negative payroll number, with unemployment trending toward 4.8% and breakevens moving only around 10 basis points – a quiet but clear signal that the bond market is not pricing a wage-price spiral. The tail risk runs in one direction only: labour market weakness is likely to become more pronounced as the year progresses, potentially accelerating easing beyond the base case.
Different mandates, different directions
The picture outside the US is more complex. Compared to the Fed, the ECB and BoE face a genuinely harder trade-off. At the time of writing, this was reflected in markets pricing two to three rate hikes later this year in euro and sterling rates.
The ECB’s inflation mandate is explicit and hard-won, and a visible commodity shock creates real internal tension. Its economies carry less labor market slack than the US, meaning the growth-inflation trade-off is less clear-cut. The BoE is navigating a consumer sector more directly exposed to energy costs alongside a labor market showing its own signs of fatigue, a combination that makes the case for holding complicated, and the case for hiking uncomfortable. Neither central bank has the same analytical cover the Fed does.
The BoC sits closer to the Fed end of the spectrum, with inflation at 1.8% and unemployment at 6.7% leaving limited justification for tightening into an energy-driven growth shock.
This divergence is not merely a central bank communications problem, it is also an investment signal. And unlike 2022, when credit markets were largely insulated from the shock that drove monetary policy, today’s credit cycle has its own fault lines: AI disruption, business development company loan books under pressure, software capital structures being repriced, a redemption cycle in semi-liquid vehicles gathering pace.
Importantly, that combination of monetary policy divergence and independent credit stress is generating opportunities across both rates and credit that did not exist three months ago.
Where the opportunities are
US Treasuries, even without their traditional safe-haven bid, reflect a central bank with a clearer easing path than its European peers. The risk in European rates runs in both directions and that asymmetry deserves to be in the price. The rise in government yields globally, while driven by the repricing of central bank expectations, is also likely being impacted by central banks and institutions needing to raise cash given rising oil prices.
Within credit, the preferred positioning is quality-oriented: BB US and European high yield, shorter duration, less cyclical and the mezzanine CLO market where dislocation is generating attractive entry points. Bonds of large-cap financials, with their high regulatory barriers and structural moats, have provided ballast throughout. Selectively, emerging market credit and certain technology names that have sold off sharply are now better priced from a bond perspective than at any point this year.
The most attractive entry points in both rates and credit exist precisely because the consensus has yet to fully reprice this cycle for what it is. This cycle will not repeat 2022. The cost of assuming otherwise is already accumulating.
|
