In the first quarter, the steep rise in interest rates over the past 12 months collided with record high debt levels, leading to the largest banking failures since 2008. Nonetheless, the bullish yield curve steepening in March has recently given way to a strong risk-on regime, with equities and credit spreads rallying and yield curves bear flattening. Market action clearly seems to imply that the cat is back in the bag. But will this persist?

We retain the view that the risk of recession has not disappeared, and that labor market weakness could be the catalyst for a change in market sentiment. For now, central banks seem to need a tie break to win their war against inflation and are extending their tightening cycles, even as headline inflation recedes and growth weakens. This reinforces our view that lower yields, steeper curve and credit opportunities will arrive in the second half.

We see the renewed hawkishness of the US Federal Reserve (Fed) but also at the European Central Bank (ECB) as a tendency to insure against the possibility of inflation staying more persistent than expected. By targeting real-time core inflation trends, they seem to be accepting the risk of over-tightening.

Markets have moved in line with this narrative. The pricing of the December 2023 Fed Fund contract says it all. In March, in the wake of the failure of Silicon Valley Bank, the contract rallied an astonishing 170 basis points (bps), completely pricing out hikes and actually pricing in Fed cuts by year-end. Since the low in mid-March, this move was nearly completely reversed after a 140 bps sell-off. Fed year-end pricing is back to levels where things started to crack for small and medium-sized US banks.