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Credit Insights

First-Quarter Fixed-Income Index Review

A fed funds rate increase did not prevent the indexes from rising.

Fixed-income indexes performed well in the first quarter of 2017, as interest rates held relatively steady and credit spreads tightened slightly. Corporate credit markets have been supported by a combination of generally improving credit metrics and the market's expectation that possible revisions to tax and regulatory policies enacted by the Trump administration will reinvigorate economic growth and earnings.

The Morningstar Core Bond Index, our broadest measure of the fixed-income universe, rose 0.85% in the first quarter. The return was generated by a combination of the yield carry on the underlying securities, as long-term interest rates had generally been flat thus far this year, and a slight tightening in corporate credit spreads. Representative of the Treasury market, the Morningstar US Government Bond Index rose 0.73%, and the Morningstar US Agency Bond Index rose 0.78%. Inflation expectations also held relatively steady, and the Morningstar TIPS Index rose 1.38%.

In the corporate bond market, the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) rose 1.38%. Since the end of last year, the average corporate credit spread of the Morningstar Corporate Bond Index tightened 5 basis points to +123. While corporate bonds performed well in the United States, the Morningstar Eurobond Corporate Index rose only 0.09%. The average corporate credit spread in the Morningstar Eurobond Corporate Index tightened only 2 basis points this past quarter. While U.S. long-term interest rates were generally steady, in the eurozone the underlying sovereign interest rates rose as the European Central Bank hinted that it is nearing the time it will begin to wind down its easy monetary policy. For example, the yield on Germany's 10-year bond almost doubled this past quarter, rising 18 basis points to 0.39%.

The emerging-markets fixed-income indexes posted the strongest returns in the first quarter among the fixed-income universe, as the Morningstar Emerging Market Composite Bond Index rose 3.45%. Underlying the composite index, the Morningstar Emerging Market Sovereign Bond Index rose 3.98%, and the Morningstar Emerging Market Corporate Bond Index rose 3.21%.

While the corporate bond market has been pricing in the expectation that revisions to tax and regulatory policies that might be enacted by the Trump administration will reinvigorate economic growth, economic activity appears to have slowed in the first quarter. Robert Johnson, Morningstar, Inc.'s director of economic analysis, expects that GDP growth in the first quarter will only be about 1.0%. He expects economic growth will rebound in the second quarter to 2.1% and will be 1.75%-2.0% for the full year. While his first-quarter estimate is below the average expectations of Wall Street economists, it is in line with the GDPNow estimate produced by the Federal Reserve Bank of Atlanta. Data over the past few weeks has led the Atlanta Fed to lower its GDPNow estimate for economic growth in the first quarter of 2017 to 0.9% from as high as 2.5% as recently as Feb. 27. Factors leading to the lower estimate include weakening construction spending, light-vehicle sales, and manufacturing reports. However, even at this slower pace, our corporate credit analysts expect economic growth should be enough to generally support the credit quality of corporate issuers and financial institutions. Among Johnson's other forecasts, he expects that at the end of this year, the yield on the 10-year U.S. Treasury will be 3.00%-3.50% and the run rate of inflation will be 2.00% on a fourth-quarter over fourth-quarter basis.

Futures Market Pricing In Additional Fed Rate Hikes
The Federal Reserve raised the federal funds rate by 25 basis points in March to 0.75%-1.00%. At the beginning of the year, the market-implied probability of a rate hike so early in the year was very low, but that rose quickly a few weeks before the March meeting of the Federal Open Market Committee as Federal Reserve officials suggested in several public speeches that a rate hike was in the offing. Even after this rate hike, both the Fed and the market expect a couple of more increases this year.

According to data from the CME, the market-implied probability priced into the federal funds futures market that the Fed will hike the federal funds rate after the June meeting is 53%. The probability that it will be over 100 basis points after the December meeting is 89%. The market-implied probability that there will be two more rate hikes this year is 55%. If the Fed were to raise interest rates two more times this year, the fed funds rate would be 1.25%-1.50% at the end of this year, in line with the Fed's median forecast, which is 1.4% at the end of 2017. If the fed funds rate rises above 1%, that would be the first time since 2008 that it has risen above what, before the credit crisis, was its previous historical low. The prior historical low was reached in 2003, when the U.S. was recovering from the tech bubble bursting.

While the Fed is tightening monetary policy in the U.S., the ECB has held its course and remains in an easy monetary policy stance. Earlier in March, the ECB decided to keep its short-term interest rates at negative yields and will maintain its EUR 60 billion monthly purchase program through year-end. However, ECB president Mario Draghi recently alluded to signs of strengthening in the eurozone and the re-emergence of inflation. Many investors took this to mean that the ECB is edging closer to dialing back its dovish monetary policy.

Morningstar Credit Ratings, LLC is a credit rating agency registered with the Securities and Exchange Commission as a nationally recognized statistical rating organization (“NRSRO”). Under its NRSRO registration, Morningstar Credit Ratings issues credit ratings on financial institutions (e.g., banks), corporate issuers, and asset-backed securities. While Morningstar Credit Ratings issues credit ratings on insurance companies, those ratings are not issued under its NRSRO registration. All Morningstar credit ratings and related analysis contained herein are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Morningstar credit ratings and related analysis should not be considered without an understanding and review of our methodologies, disclaimers, disclosures, and other important information found at https://ratingagency.morningstar.com.