Equity Market Assumes Rates Will Stay Low for Longer; Corporate Bond Market Not Quite as Convinced
Fed intimates that rates will rise at a slower pace.
The equity market rose sharply off its lows after the Federal Open Market Committee released its meeting statement and updated economic projections. Based on the changes in the FOMC's language and revisions to its economic forecasts, equity investors are betting that the Fed will keep short-term interest rates lower for longer. The corporate bond market, however, is not quite as convinced.
Corporate credit spreads initially widened at the beginning of last week. The corporate bond market was having a tough time digesting the vast amount of new corporate bonds that had been priced over the prior three weeks, and declining oil prices pressured credit spreads in the energy sector. The tone of the corporate bond market changed for the better after the FOMC statement, but credit spreads were unable to fully retrace the amount they widened out earlier in the week. Traders began to cover short positions and higher bids from institutional investors quickly followed, yet the demand was not great enough to push corporate bonds up to the same degree that equity prices rose.
For the week, in the investment-grade bond market, the average spread of the Morningstar Corporate Bond Index widened a total of 4 basis points to +138. In the high-yield market, the Bank of America Merrill Lynch High Yield Master Index widened 13 basis points to +481. In the junk bond market, the weekly fund flows in open and closed end funds were negative through last Wednesday, the second week in a row. However, we suspect that if the jump in the equity market holds its gains at the beginning of this week, then investors will be confident enough to return to the high-yield market.
Over the next few months, we expect that corporate bonds will remain well bid. As the European Central Bank's asset-purchase program prints new money to purchase sovereign bonds and asset-backed securities, the path of least resistance will be to reinvest those proceeds in corporate bonds. Much of the recent demand in the U.S. corporate bond market has been attributed to foreign investors in developed markets looking to pick up the higher all-in yield U.S. corporate bonds offer and invest in the safety of the strengthening dollar. Currently, the average yield of our U.S. corporate bond index is 2.91% as compared with our European corporate bond index at 0.78%. Even after adjusting for the longer duration of the U.S. index, investors are picking up significantly more yield in the United States.
Considering the all-in yield on European corporate bonds is less than half of that in the U.S. and investors expect that the U.S. dollar will continue to strengthen versus the euro, global investors have been reallocating principal into the U.S. market. In addition, the Bank of Japan continues to weaken the yen with its own asset-purchase plan, which has prompted some Japanese fixed-income investors to also reallocate their asset mix to the U.S. corporate bond market.
Fed Intimates That Rates Will Rise at a Slower Pace
As expected, the Fed dropped the language in its meeting statement that "it can be patient in beginning to normalize the stance of monetary policy." This language was replaced with the statement that "it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2% objective over the medium term." With this change, the Fed has now positioned itself to raise rates at any meeting that it deems the appropriate time to start tightening monetary policy. However, this change was accompanied with a downgrade in economic and inflation projections.
1The central tendency excludes the three highest and three lowest projections for each variable in each year.
3Longer-run projections for core PCE inflation are not projected.
The markets' interpretation of these reductions is that the Fed has provided itself additional room to leave the federal funds rate near zero for a longer time than otherwise may have been warranted under the prior projections.
The Fed also specifically stated that it was unlikely to increase the federal funds rate at the April FOMC meeting. It will be instructive to see after the April meeting whether the Fed specifies that it is unlikely to raise rates after the June meeting. If it does not make that specification, then the market may interpret that omission as a signal that the Fed will raise rates in June; however, if the Fed does state it is unlikely to raise rates in June, then it will have seemingly set a precedent about commenting on rate actions at future meetings.