Two weeks ago, we noted the market's difficulty digesting a prodigious serving of new issuances, as some investors were looking to lock in profits for the year early and others seem to have begun year-end window-dressing early this year. This led to a bout of heartburn as the market tried to digest the new supply, and corporate credit spreads had to widen out to attract investors. This trend continued early last week, but once the new supply was absorbed by midweek, the corporate bond market began to recover in the latter half of the week. By the end of the week, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) had widened 1 basis point to +105. The high-yield market, after widening as much as 20 basis points by midweek, recovered its losses, and the BofA Merrill Lynch High Yield Master Index ended the week unchanged at +376.
Although corporate credit spreads have bounced off their recent lows, financial conditions in the United States remain highly accommodative. The Federal Reserve Bank of Chicago publishes a weekly index that measures more than 105 variables to gauge how loose or tight financial conditions are in U.S. capital markets as well as the traditional and shadow banking systems. These variables include credit availability and cost, leverage, risk, interest rates, and credit spreads. Index levels above zero indicate tighter-than-average conditions, whereas levels below zero represent looser-than-average conditions. The National Financial Conditions Index is currently showing that financial conditions are at their loosest since October 1994.
As corporate credit spreads widened over the past few weeks, the negative sentiment pressured many issuers to hold off accessing the public capital debt markets last week. Typically, there will be a surge of new issuances during the week before Thanksgiving. At that time, issuers have exited self-imposed quiet periods before the release of third-quarter results and are looking to take advantage of the narrow window to the new issue market before the beginning of the holiday season the following week. A few issuers that held off last week will probably tap the market early this week, but those issues will need to be priced Monday or Tuesday; otherwise, issuers will need to wait until after the Thanksgiving holiday.
While the yield on the 2-year Treasury bond rose another 7 basis points to 1.72%, hitting its highest level since October 2008, interest rates fell across the long end of the curve. The yield on the 10- and 30-year Treasury bonds declined 6 and 10 basis points, respectively, ending the week at 2.34% and 2.78%. The yield on the 2-year bond has been trending steadily higher for several years and has outpaced the increase on longer-term bonds. As such, the yield curve has been flattening, and the spread between the between the 2-year and the 10-year has tightened.
Historically, a flattening yield curve has been a leading indicator of a potentially weakening economy, However, this time around, this signal may be distorted by global central bank actions. The short end of the curve is being directly influenced by the Federal Reserve, which is hiking short-term rates, while the long end of the curve may be influenced by the ongoing quantitative easing programs of the European Central Bank and Bank of Japan. Even though the 10-year U.S. Treasury is yielding only 2.34%, that yield is attractive to global bond investors, as the yield on Germany's 10-year bond is 0.36% and the yield on Japan's 10-year bond is barely positive at 0.04%. From an economic perspective, growth in the short term appears to be healthy. GDP was reported to be a relatively strong 3.0% in the third quarter, and the GDPNow model forecast produced by the Federal Reserve Bank of Atlanta for real GDP growth in the fourth quarter was just increased to 3.4%.
This flattening trend may continue to be influenced by global central bank monetary policy. While the Fed held off on raising short-term interest rates at its November meeting, the futures market for the federal funds rate has priced in an interest rate hike following the December Federal Open Market Committee meeting as fait accompli. Based on CME Group's FedWatch Tool, the market is pricing in a 100% probability of a rate hike in December. The European Central Bank announced that it would not begin to taper its asset-purchase program until next year. Even then, it will continue to purchase EUR 30 billion per month until September 2018 and noted that the purchases could be extended, if warranted. While this places the ECB on the path to a more normalized monetary policy late next year, these purchases will still infuse the eurozone with an additional EUR 270 billion of new money that will need to find a home somewhere, and the ECB's main financing rate remains at 0%.
High-Yield Outflows Surge as Credit Spreads Widen
Outflows among high-yield mutual funds and exchange-traded funds surged to $4.2 billion last week, the fifth consecutive week of outflows. This outflow represented the third-greatest amount of weekly outflows we have recorded since we began tracking fund flows in June 2009. The second-largest outflow of $5.3 billion occurred in March 2017 following the Fed's increase in the federal funds rate in conjunction with weakness in oil prices, which slipped below $50 in mid-March. The single-greatest weekly outflow of $6.7 billion occurred in August 2014 when oil prices began to crack and were poised for a free fall.
The outflows consisted of redemptions of $2.3 billion among open-end funds and $1.9 billion in ETFs. Over the past five weeks, the total amount of outflows is $6.0 billion, split nearly equally between open-end high-yield mutual funds and high-yield ETFs. The amount of outflows over the past month represents well over half of the outflows the high-yield asset class has registered this year. Year to date, the high-yield asset class has suffered total redemptions of $11.6 billion, consisting of $13.7 billion of redemptions in open-end mutual funds offset by $2.1 billion of new unit creation in ETFs. Typically, ETFs are considered a proxy for institutional investor demand, which is often more correlated to changes in the corporate credit spread, whereas open-end funds are considered a proxy for individual investors and correlated to changes in the absolute yield.
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