Reaction to eventful Monday bodes well for markets

Monday was a somewhat eventful day for markets with several headlines in the US and Europe. Risk assets did not necessarily reflect the eventfulness of the day, finishing virtually unchanged, while rates had a volatile day that ultimately produced a sizeable rally.

The main news was that the US is no longer a AAA credit. Moody’s stripped the US of its last remaining AAA rating at close of business on Friday, meaning Monday was the first opportunity to gauge the market’s reaction. In London trading hours the trend was for higher yields in US Treasuries (USTs), which dragged Gilts and Bunds with them. But as the day progressed in the US, these dynamics reversed abruptly and yields finished the day lower. The 30-year UST exhibited the most volatility, touching 5.03% at one stage having opened at 4.96%, only to rally to 4.90% at the close. The 10-year followed a similar pattern with a 12bp rally from its intraday high to close at 4.44%.

It is not good news that the largest risk-free asset in the world suffers a downgrade in credit rating. The Moody’s view is that credit risk has increased as a result of years of very high budget deficits and not much prospect for improvement. Markets are eagerly awaiting the outcome of the reconciliation bill that is making its way through Congress, but it has become clear this is not about to provide a solution to the debt issues. There are a number of tax cut extensions and new tax measures, offset by spending cuts and monies from tariffs, but it is too early to tell what the numbers will look like. The main drivers for USTs in the coming months will likely be the opposing forces of a potentially higher fiscal deficit and an economy decelerating more quickly than expected at the beginning of the year as a result of tariffs. The added complication is that the latter might cause inflation to increase, at least in the short term, and volatility in rates is likely to continue as a consequence.

Over in Europe, there was an agreement between the UK and the European Union (EU) for a post-Brexit relationship. While this is positive news, much like the US-UK trade deal last week, the headline is bigger than the actual content. According to the UK government, the deal with the EU will add £9bn to the UK economy by 2040, equivalent to 0.3% of GDP. The main points include the removal of some food checks at the border, a 12-year agreement on UK waters fishing rights, cooperation in defence, and a roadmap for talks in the future on youth mobility and other areas. We deem the agreement as a small step towards finding a new post-Brexit equilibrium in the UK’s relationship with the EU.

Separately, the EU Commission released its spring economic forecasts. These are reasonably important as they are used to propose policies in the EU that involve the economy. Though there were no surprises, it is yet another forecast that confirms the expectation that inflation is not suffering many changes as a consequence of tariffs, while the growth impact, though negative, is not as large as in the US. Growth is expected to land at 0.9% for 2025 with an acceleration in 2026, down from 1.3% in the Commission’s Autumn 2024 projections. Q2 is expected to be the weakest quarter of the year with a pickup thereafter. Only Austria is expected to have negative growth this year, with Germany at 0%. Regarding budget deficits, the forecast for the Eurozone is up from 2.9% to 3.2%. While this is not necessarily good news, it is in stark contrast to the Moody’s release on the US rating, which anticipates the deficit increasing from 6.4% of GDP last year to 9% by 2035.

For the week ahead, the main news will be the Purchasing Managers’ Index (PMI) data release on Thursday for the US, UK, and several countries in Europe. These PMIs will provide an early indication of how the trade war may be impacting business sentiment and activity, and any downside surprises could raise concerns about near-term growth momentum. The Bloomberg consensus is perhaps surprisingly close to last month’s numbers, with the expectation being for flattish prints on average across the board. Manufacturing is expected to continue to fare worse than services in most countries, but there are no expectations for a dramatic adjustment just yet. While we expect hard data to deteriorate as the year progresses, this is somewhat consistent with our view that a recession is not a base case.

The fact that markets have largely shrugged off the US downgrade news, along with marginally positive news in the Europe, bodes reasonably well for markets. Provided that trade deals are eventually negotiated, and tariffs end up being in the 10-12% region, it looks like we might be moving towards a scenario that might have similarities with the one expected at the beginning of the year. This is one where strong corporate and consumer fundamentals keep default rates in check in the context of a global economy that is decelerating, led by the US. Admittedly, growth prospects are worse than at the beginning of the year and the trade war is far from over, both of which argue for spreads to not be at the very lows of the cycle.

At the same time, the probability of a recession has decreased markedly since the beginning of April and the demand for fixed income remains very strong. As such, a deep sell-off looks unlikely to us. We remain cautiously overweight credit and expect carry to outperform under our non-recession base case.