May Market Review

May ended with strong increases in equity indices and slight declines in fixed income indices, due to the rise in long-term interest rates.

• S&P 500: +6.15%
• Nasdaq: +9.04%
• Stoxx Europe: +4.02%
• All Country World Index EUR: +5.98% (the dollar rose by 0.16%, so in dollars the increase was 5.82%).
• Global Fixed Income Index EUR: -0.22% (the dollar fell by 0.16%, so in dollars the change was -0.38%).

It appears that the market is somewhat calmer regarding the tariffs announced by Trump, who has temporarily suspended these increases while awaiting agreements in the upcoming negotiations with various countries. However, there is a tense calm due to movements in the fixed income market that generate concern.

What is happening in fixed income? Inflation is decreasing slowly, credit is cooling down, and government debt continues to rise. All of this affects the market, but the drop hasn’t been very pronounced. So, why worry?

This image shows the yield curve, a graphical representation of the different maturities of U.S. Treasury bonds (it could be any type of bond, but we focus on U.S. Treasuries because they are the global benchmark) with the corresponding interest rates for each maturity.

Source: Bloomberg

These rates are set by the market through supply and demand. The U.S. Central Bank (FED) only determines the “overnight” interest rate (the rate at which banks lend to each other day by day). As can be seen, the one-year interest rate is at 4.04%, the two-year at 3.875%, the five-year at 3.927%, and so on.

Why do the interest rates on this curve move? If investors heavily demand 10-year bonds because they find the offered yield attractive, the bond price rises, but the interest rate falls. Why? Bonds are usually issued at a price of 100, and the rate is set in advance based on market conditions. Suppose a 5% rate is set, so the bondholder receives a €5 coupon annually or at the agreed frequency. Bonds are traded in a market with buyers and sellers. If the bond starts being in high demand because the interest rate is attractive, its price begins to rise—let’s say to €105—yet the coupon remains the same at €5. So, what is the new yield for a bond bought at €105? It would be 5€/105 = 4.76%. When investors find a bond attractive and buy it in large quantities, the price goes up but its yield goes down.

That said, what is worrying investors is the rise in long-term rates. In the next graph, you can see the evolution of the yield curve from April 2 (black line) to June 5 (blue line).

Source: Bloomberg.

In the ovals, I highlight the rise in rates at the 10-year and 20-year maturities in just one month.

• 10-year increased from 4.13% to 4.35% (+22 basis points).
• 20-year increased from 4.53% to 4.86% (+33 basis points).

What is driving this increase? Long-term rates (from 7 years onward) can rise due to the following three fundamental reasons[1]:

• Economic improvement. Companies seek more debt to invest in more projects as a result of this perceived improvement. This increases demand for bonds and thus interest rates. Moreover, bonds are sold to buy riskier assets such as equities. And what happens to interest rates in this scenario? They rise. Higher returns are demanded from financial assets. This could be seen as a positive scenario.

Is there really an economic improvement? In this graph showing GDP (Gross Domestic Product) evolution, a downward trend is evident.

Source: Bloomberg

And in this graph, which represents expected new orders in manufacturing and service sectors, there is also a downward trend, suggesting these sectors are not experiencing significant improvement.

Source: Bloomberg

Looking at these two examples, it is reasonable to conclude that the rise in long-term interest rates is not due to a broad economic improvement.

• Higher expected inflation. If you expect inflation to be 5%, you wouldn’t buy bonds yielding 5% because you’d lose all your purchasing power. Instead, you’d sell those bonds (what happens to interest rates then?) and buy other assets that protect against inflation.

This graph shows 10-year inflation expectations. Currently, inflation is expected to be 2.31%, and it currently sits at 2.30%. This suggests no inflation increases are foreseen in the long term.

• Issues with national accounts. If investors suspect that a country’s finances are deteriorating, they prefer to stop or reduce investment amounts. The U.S. deficit continues to grow, and debt-to-GDP is at 120%. The U.S. pays around $1T annually in interest, more than its defense spending. Moody’s downgraded the debt rating, and the CDS (default insurance) peaked at 56 points in May, compared to 33 in February.

It makes sense that the rise in long-term rates is due to a loss of confidence in the U.S. economy and its currency, caused by excessive spending far beyond its revenue.

Although the increases in 10- and 20-year rates may seem small, they have significant implications in the financial world, especially since they are causing investor concern.

Investors are selling U.S. Treasury bonds and are not showing up at auctions as before. On May 21, there was a $20Bn Treasury bond auction with unusually weak demand. As a result, 20-year rates rose sharply, surpassing 5%. This coincided with a 1.6% drop in the S&P 500, a -0.50% fall in the dollar, and a 1% rise in gold.

The Trump administration had promised to cut unnecessary spending while also lowering taxes. During the campaign, these promises were expected to generate $2 trillion in savings. However, by January 30, 2025, this had been reduced to $1 trillion and finally to $155 billion. The forecasted deficit for 2025 is $7 trillion, or 6.2% of GDP. By the way, the disagreement between Elon Musk and Trump stems precisely from this issue.

How will they finance this growing deficit?

• Taxes? Trump wants to cut them.
• Print more money? A measure that could generate inflation.
• More debt? They could issue more debt, but we’ve seen that in one of the auctions, they had to increase yields to attract demand. It’s a vicious cycle: more debt is issued, investors demand more yield, which raises costs, and so on.

I believe the bond market is signaling a warning, as this is not only happening in the U.S., but globally, as shown in this image.

Source: FMI, Incrementum

This chart shows the deficit (the more negative the number, the larger the deficit) to GDP ratio in each of these countries, with the trend rising everywhere except Italy, where the “Superbonus” has been eliminated. The deficit rose sharply in 2020 due to COVID, when spending increased to help households. Although this spending was claimed to be temporary, it now seems it could return to those levels.

What are the implications?

1. Higher yields required for financial assets: As I’ve mentioned before, the U.S. 10-year interest rate is a benchmark for riskier investments. We saw earlier that the U.S. 10-year rate is currently at 4.35%, so any other investment in dollars should offer a higher return. How much higher? That depends on the perceived risk. Investing in a very defensive company is not the same as investing in a risky one; the former will require a smaller spread, but always above 4.35%.

If I demand higher returns from financial assets, my entry price must be lower than previously estimated in order to increase that return. So far, rate increases aren’t very steep, but they must be monitored closely.

• Rising government debt: If governments keep increasing debt and offer higher yields to make it attractive (higher interest rates), it could crowd out private corporate debt. Why? Because if market interest rates rise, companies will have less capacity to finance themselves at low rates, which can be problematic.

• Currency destruction due to excessive deficit: An excessive deficit devalues the currency, as investors lose confidence in the country, creating inflationary pressures. Central banks around the world are reducing U.S. bond purchases and stockpiling gold. As evidence, the dollar has fallen 10.4% so far this year.

So should we sell everything due to the perceived risk? Absolutely not. We must discern where to invest. The conclusions I draw from the three points above for the world of investing are:

• Demand higher returns from assets.
• Avoid highly indebted companies.
• Seek assets that protect against potential inflation increases.

Therefore, in my humble opinion, investment should target companies with high Return on Capital Employed (ROCE), meaning companies with high, sustainable, and growing returns over time and low debt. Inflation is best fought by investing in real assets—and companies are real assets—and if there is cash, it should be converted into gold to preserve purchasing power.

[1] Why has the cost of US public debt skyrocketed? – Podcast by Juan Ramón Rallo | Podcast on Spotify. Min 0,55.