Corporate Credit Spreads Tighten as Risk Assets Back in Favor
Monetary policy expected to begin tightening at measured pace.
Risk assets were back in favor last week as corporate credit spreads tightened, stocks rose to new highs, and safe-haven Treasury bonds sold off. Volatility was elevated in the prior few weeks, but the VIX Index has dwindled to 10.2 as hurricanes Harvey and Irma caused only short-term market dislocations and investors have become inured to North Korean rocket launches (12 so far this year) and habituated to minor terrorist attacks in Europe. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) tightened 4 basis points to +111 last week and the average credit spread of the BofA Merrill Lynch High Yield Master Index tightened 19 basis points to +373.
Interest rates on U.S. Treasury bonds had declined since early spring and two weeks ago hit their lowest levels since the presidential elections. However, the Treasury bond market weakened last week and interest rates surged higher. The yield curve rose anywhere from 10 to 17 basis points, with the belly of the curve, consisting of the 5-year and 10-year, performing the worst. At the end of business Friday, yields on the 2-year, 5-year, 10-year, and 30-year were 1.38%, 1.81%, 2.20%, and 2.77%, respectively, increasing by 12, 17, 14, and 10 basis points. In Europe, interest rates also rose with Germany's 10-year sovereign bond climbing 12 basis points to 0.43%, Italy's 10-year bond rising 12 basis points to 2.02%, and Switzerland's 10-year making a run for zero by increasing 11 basis points to negative 0.05%.
Monetary Policy Expected to Begin Tightening at Measured Pace
The next Federal Open Market Committee meeting of the Federal Reserve is scheduled for Sept. 19-20. The market expects the Fed to announce that it will begin its balance sheet reduction program in October. This program will scale back the Fed's current reinvestments to allow $10 billion of assets to roll off per month and then increase the pace of reduction by $10 billion until it reaches a total monthly runoff rate of $50 billion (an annual run rate of $600 billion). To put the run rate in context, the total amount of assets currently held by the Federal Reserve banks is $4.45 trillion.
While market expects the Fed will begin to reduce the size of its balance sheet in the near term, it remains uncertain whether the Fed will hike the federal funds rate one more time before the end of the year. The market-implied probability of the latter happening has surged to 58% from 31% a week ago.
The European Central Bank has implied that it will announce at its October meeting its plan to begin winding down its asset-purchase program in 2018; however, the ECB will continue its quantitative easing program of purchasing EUR 60 billion of bonds per month through the end of this year (approximately another quarter trillion).
High-Yield Fund Flows
Through the week ended Sept. 13, high-yield exchange-traded funds and open-end mutual funds experienced an outflow of $0.3 billion. The outflows were concentrated in the ETF sector as the fund flows across open-end mutual funds were essentially unchanged.
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