Contagion From Equity Market Volatility Spreads to Corporate Bond Market
The spike in volatility last week drove a "risk off" sentiment among investors, which sent prices of risky assets down across the board.
Two weeks ago, we noted that the corporate bond market had sailed into increasingly choppy waters as contagion from the spike in equity volatility spread into other asset classes. Last week, the turbulence increased as equity market volatility continued to swing wildly and decimated exchange-traded funds that were created to short volatility. The spike in volatility drove a "risk off" sentiment among investors, which sent prices of risky assets down across the board.
The equity market took the brunt of the selling, sending the S&P 500 down 5.84% last week; this put the equity market into negative territory for the year. In the corporate bond market, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened 9 basis points to +97 basis points. In the high-yield market, the BofA Merrill Lynch High Yield Master Index widened 46 basis points to end the week at +382. Excluding the abnormal market action during the 2008-09 global financial credit crisis, this is one of the largest weekly swings in the high-yield index of the past 20 years.
While this sudden downturn has felt severe, it only brings the markets back to levels at which they were trading within the past few months. For example, even after this sell-off, the S&P 500 is still trading at the same level it was just 10 weeks ago, at the end of November 2017. The average credit spread of the investment-grade index is now only 1 basis point wider year to date, and it is still 31 basis points tighter than at the end of 2016. The high-yield index may be 19 basis points wider year to date, but it is still 39 basis points tighter than at the end of 2016.
Risk Off Sends Investors to Short-Term U.S. Treasury Notes, but They Still Avoid Long-Term Bonds
As risk assets sold off, investors flocked to the safety of short-term, risk-free assets. The yield on the 2-year Treasury note declined 7 basis points to 2.07%, and the 5-year Treasury note fell 5 basis points to 2.54%. Even with these declines, the yield on these notes remained near their highest levels since 2008 and 2009, respectively. While yield on short-term notes declined, however, the yield on long-term bonds rose. The yield on the 10-year Treasury bond rose 1 basis point to 2.85%, and the 30-year Treasury bond increased 5 basis points to 3.16%.
Since their most recent low in mid-2016, inflation expectations have been on an upward trend. For example, the 5-year, 5-year forward inflation expectation rate has risen to 2.30%, its highest level since fall 2014. The 5-year, 5-year forward inflation expectation rate is the market-derived expectation for the average inflation rate for 5 years, beginning 5 years in the future.
Following the sell-off last week, investors are re-evaluating their expectations for further interest rate hikes. According to CME Group's FedWatch Tool, the market-derived probability that the Federal Reserve will raise the federal-funds rate at its March meeting declined to 72% from 78% the prior week. The probability of further rate hikes through the rest of the year has also declined. For example, by the end of last week, the probability that the federal-funds rate at the end of 2018 will be greater than 1.75% had declined to 81% from 88%, and the probability that the federal-funds rate will be 2% or higher declined to 48% from 59%.
The March Federal Open Market Committee meeting will be especially closely watched, as it will be the first time that newly elected Federal Reserve Chairman Jerome Powell will hold a press conference and take questions. The market will scrutinize his answers to divine any differences in his view of monetary policy compared with that of the prior Fed chair. In addition, investors will be looking for any changes in the Fed's updated Summary of Economic Projections. At the December 2017 meeting, the average projected federal-funds rate of the board members for the next three years was 2%, 2.70%, and 3% for the years ended 2018, 2019, and 2020.
For Fourth Consecutive Week, Investors Pull Assets Out of High-Yield Funds
For the fourth consecutive week this year, investors pulled assets out of the high-yield market. For the week ended Feb. 7, high-yield open-end funds and exchange-traded funds experienced a net outflow of $2.5 billion. This consisted of $1.3 billion of withdrawals from open-end funds and $1.2 billion of unit redemptions from ETFs. Over the past four weeks, outflows total $8.0 billion. Since June 2009 (when we first began measuring high-yield fund flows), there have been only six instances in which fund outflows have been $8.0 billion or more. The most recent instance was at the end of 2015; the other instances occurred in mid-2014 and mid-2013.
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