While the economic backdrop is reasonably robust, we remain watchful of potential volatilities in the coming weeks. With lower interest rates expected as we head into year end, we think current yield levels are reasonably attractive and may not be sustained for much longer. We are Neutral on Developed Markets (DM) Investment Grade (IG) and DM High Yield (HY) bonds. In Emerging Markets (EM), we move IG to Neutral (from Underweight) and maintain an Overweight in HY. We remain Neutral on duration, preferring the front-end and intermediate maturities.

Rates and US Treasuries

The Fed delivered a 50 basis points (bps) rate cut in the September Federal Open Market Committee (FOMC) meeting, with a larger-than-expected move justified by the slowing labour market and the confidence that inflation would reach the Fed’s 2% goal. More importantly, the Fed’s new forecast implied only 25bps cuts in future. As a result, 10Y US Treasury (UST) yields were modestly higher post-rate cut and the 2Y/10Y US Treasury curve further steepened.

With the Fed acknowledging further progress on price stability, focus will now shift towards the other side of the Fed’s dual mandate – employment. 

The market is pricing in about 200bps of cumulative cuts over the next 18 months. At the same time, however, we remain cautious of upside risks to the inflation impulses (driven by tariffs, tax breaks or fiscal stimulus) resulting from the US presidential election in November. This could raise the outlook for upside surprises on inflation further down the road.

While the proximity to the first potential interest rate easing supports lower yields over the near term, we maintain a Neutral positioning on duration. Over the next 12 months, we see limited scope for a further rally in long-end yields, but the risk of further steepening of the yield curve could be driven by upside surprises in inflation expectations.

Reflecting these expectations, we maintain a Neutral position on duration. We view the front and intermediate term as offering the best protection from rates volatility.

Developed markets

Fed cuts in a non-recessionary environment should garner inflows into credits, as it presents investors with a chance to lock in yields as the global easing cycle begins. If incoming data continues to validate a soft-landing outcome, spreads could remain tight. At this point, the clearest risk is a quick deterioration in the labour market. While that could trigger more aggressive Fed cuts, it could also be a headwind for spreads, likely resulting in modest total returns. Hence, we reiterate our preference for defensive positioning by staying up in the quality curve.

Averaging past rate cut cycles, IG has a strong track record of outperforming HY when rate cuts begin. IG is more sensitive to rates unlike HY which is more sensitive to spread movements and default risks.

At the same time, there is an also an opportunity cost of being underweight a positive carry asset. Therefore, we think the optimal strategy is to pick carry by going down the ratings spectrum into the better quality within HY (i.e. “BB”-rated segment) while avoiding excessive spread duration risk.

Emerging markets

We have a modest Overweight stance on EM credits, with a preference for HY over IG. EM IG should benefit from the lower rate tailwind during the rate cut cycle. We remain Overweight in EM HY due to the attractive carry returns.

Asia

In line with overall EM views, we are Neutral Asia IG and Overweight Asia HY. For Asia IG, its comparatively shorter duration, stable fundamentals and lower market beta should keep spreads range bound. We continue to like the attractive carry for Asia HY.

The coordinated and successive series of stimulus announcements by the Chinese authorities in late September has significantly boosted sentiment. China HY turned in a strong performance last month, with outsized gains in the surviving names in the property space, despite limited new housing policy measures. We reiterate that game-changing housing easing measures would likely require direct central government intervention.

We maintain our overall Neutral view on China credits and prefer to stay with quality names. Within Greater China, we like the asset management companies (AMC), select Chinese industrial names, HK insurance sector and Macau gaming sector.

We are overall constructive on Macau gaming on continued gross gaming revenue (GGR) recovery (albeit at a gentler trajectory), deleveraging trends and improved sentiment towards China.