Relatively Quiet Week Allows Repositioning Ahead of Quarterly Earnings
Pace of economic growth in China slows; investors bet on additional easing.
Corporate credit spreads traded sideways for most of last week and widened slightly Friday as the equity markets took a hit. The average spread of the Morningstar Corporate Bond Index widened 2 basis points to +132 by the end of the day Friday, and the Bank of America Merrill Lynch High Yield Index widened 6 basis points to +466. A few new issues were priced in the financial sector during the week after the larger banks reported earnings, but the pace of new issue volume remained substantially below the deluge of new bonds brought to market in February and March. Even though earnings season officially began last week, news flow was relatively modest as the preponderance of earnings reports begin in earnest this week. With new issue volume low and headlines quiet, portfolio managers and traders used the opportunity to move bonds around and reposition their portfolios. The main theme we heard was duration extension trades, as some investors looked to lengthen their portfolios from a 5-year average life to closer to 7 years. However, even with some investors lengthening their portfolios, there was no shortage of bids for short-dated paper. European and Japanese investors who have been buying short-dated paper over the past few months continued to reallocate assets from bonds denominated in euros and yen into U.S. dollars. By swapping out of lower-yielding fixed-income securities denominated in euros, these investors are able pick up the higher all-in yield that U.S. corporate bonds offer and invest in the safety of the strengthening dollar.
Treasury bonds rallied over the course of the week. On the longer end of the curve, the 5-year Treasury tightened 11 basis points to 1.29%, the 10-year Treasury tightened 10 basis points to 1.85%, and the 30-year Treasury tightened 8 basis points to 2.50%. The combination of weak economic releases along with dovish commentary from several Fed members prompted investors to bet against an increase in the federal funds rate in June and assume that the Fed will stay lower for longer; however, this hypothesis will be tested over the next few months. Investors will need to keep a sharp eye on the next few economic releases. While the Fed has cited lower-than-targeted inflation as one of the reasons to keep a zero-interest-rate policy in place, the consumer price index revealed that on a year-over-year basis, core inflation excluding energy has still risen at a 1.8% pace, not that far from the Fed's 2% target. With oil prices stabilizing and expected to rise in the second half of the year, headline inflation should also rise. In addition, with unemployment already down to 5.5%, if the economic weakness over the past few months has really been driven by worse-than-usual weather and the economy rebounds, it will be increasingly difficult for the Fed to rationalize keeping interest rates at zero.