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Credit Insights

Volatility-Induced Turbulence Subsides

Hotter-than-expected inflation sends short-term rates higher.

The volatility-induced turbulence that spread into the corporate bond market in early February subsided last week as equity prices rebounded sharply. The S&P 500 rallied 4.30% and recovered well over half of its recent downturn. As the equity markets soared and volatility dwindled, investors exited flight-to-safety trades, which pushed short-term interest rates higher. In the corporate bond market, investment-grade corporate credit spreads generally held their ground while high-yield spreads tightened considerably. In the investment-grade market, investors balanced the desire to purchase corporate bonds at wider spreads with wanting to avoid the negative impact of rising interest rates, which will offset the benefit of the wider corporate credit spreads.

The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened 1 basis point to +98 basis points. In the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened significantly as the average spread of the index declined 32 basis points to end the week at +350. As the markets normalized throughout the week, it drove a risk-on sentiment, which prompted investors to chase riskier assets higher. Whereas the investment-grade market is more correlated with the Treasury bond market in the short term, the high -yield market has historically been much more correlated with the equity markets. High-yield bonds are much less sensitive to movements in underlying interest rates because a significantly larger portion of the total return in the high-yield market is driven by credit spreads. High-yield credit spreads represent a much larger portion of total return for the asset class as opposed to the investment-grade sector, where much less of the total return is driven by the credit spread.

Hotter-Than-Expected Inflation Sends Short-Term Rates Higher
At 0.5%, the headline month-over-month increase in the consumer price index was much higher than consensus expectations. Even the core CPI, which excludes notoriously volatile food and energy prices, rose at a 0.3% rate on a month-over-month basis. On an annualized basis, the increase in the core CPI equates to a 2.9% inflation rate, the highest in six years. While the year-over-rate rate held steady at 2.1%, the market began to price in higher near-term inflation expectations. This resulted in an increase in the market-implied probability that the Federal Reserve will increase the federal-funds rate at the March meeting as well as through the remainder of the year. According to the CME FedWatch Tool, the probability that the Fed will lift rates after the March meeting rose to 83% from 72% the prior week. After declining during the market sell-off, the probability of further rate hikes through the rest of the year bounced higher. For example, by the end of last week, the probability that the fed-funds rate at the end of 2018 will be greater than 1.75% increased to 90% from 81%, and the probability that the fed-funds rate will be 2% or higher increased to 61% from 48%.

Compounding the inflationary headwinds in the short-term bond market, as the markets recovered from the volatility-induced sell-off earlier this month, investors no longer felt the need to hide in the safe haven of short-term U.S. Treasuries. As investors dumped short-term Treasuries, the prices fell and thus interest rates rose across the shorter end of the yield curve. The yield on the 2-year Treasury note rose 12 basis points to 2.19% and the 5-year Treasury note increased 9 basis points to 2.63%. The yields on both of these notes ended the week at their highest levels since 2008 and 2010, respectively.

The movement at the long end of the yield curve was much more muted, as those bonds were not as affected by the flight-to-safety trades as the short end. The yield on the 10-year Treasury bond rose 2 basis points to 2.87% and the 30-year Treasury bond decreased 3 basis points to 3.13%.

The March Federal Open Market Committee meeting will be especially closely watched as newly elected Federal Reserve Chairman Jerome Powell will hold a press conference and take questions following the meeting. The market will scrutinize his answers for any changes in his view of monetary policy compared with the prior Fed chair. In addition, investors will be looking for any changes in the Fed's updated Summary of Economic Projections. According to projections from the Fed's December 2017 meeting, the average projected federal-funds rate of the board members for the next three years is 2%, 2.70%, and 3% for the years ended 2018, 2019, and 2020.

Second-Greatest Weekly Outflows Among High-Yield Funds and ETFs
Investors continued to flee from high-yield bonds. For the fifth consecutive week this year, investors pulled assets out of the high-yield market. For the week ended Feb. 14, high-yield open-end funds and exchange-traded funds experienced a net outflow of $6.2 billion. This consisted of $3.4 billion of withdrawals from open-end funds and $2.8 billion of unit redemptions from ETFs.

Since June 2009 (when we first began measuring high-yield fund flows), there has been only one instance in which weekly fund outflows were greater. That record outflow of $6.7 billion occurred in August 2014, when oil prices began to plunge. On a rolling four-week basis, fund outflows are currently at $10.9 billion. Over our historical data, there are only two instances in which a rolling four-week period suffered even greater outflows. Those were at the beginning of August 2014, which experienced a four-week outflow of $12.3 billion, and the end of June 2013, which recorded an outflow of $11.5 billion.

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