Bond Market Activity Returns to Normal
Activity across the fixed-income markets was generally back to normal after a wild ride in early February.
Although credit spreads in the corporate bond markets widened slightly at the end of last week, activity across the fixed-income markets was generally back to normal after a wild ride in early February. Changes in interest rates and credit spreads were muted, and the decrease in volatility led to a reopening of the window to the new issue marketplace. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) widened 2 basis points to end the week at +100. In the high-yield market, the average spread of the BofA Merrill Lynch High Yield Master Index also widened slightly, by 8 basis points to +358.
The yield on the 2-year Treasury note rose 5 basis points to end the week at 2.24%, just below its highest level since September 2008. Prices were mostly flat across the belly of the curve as the 5-year Treasury note decreased 1 basis point to 2.62% and the yield on the 10-year Treasury bond was unchanged at 2.87%. The yield on the 10-year traded within spitting distance of the 3% psychological barrier earlier in the week before retracing lower as investors took advantage of the higher yield and pushed it back down. In the long end of the curve, the yield on the 30-year Treasury bond rose 3 basis points to 3.16%.
Early this year, we noted that the spread between the yield on the 2-year and the 10-year Treasury bonds had been on a long-term downward trend and was its lowest since before the 2008-09 global financial crisis. That trend was interrupted by the spike in volatility in early February, but now that volatility has subsided, the downward trend has resumed. At the end of last week, the spread declined to 63 basis points from as high as 78 basis points on Feb. 9, but it is still above the low of 50 basis points reached in January. The yield curve has flattened as short-term rates have risen in conjunction with the increases in the federal-funds rate as the Federal Reserve continues to normalize monetary policy.
In the past, a flattening yield curve often indicated a weakening economy and in many cases portended a recession. This time around, it may not be foreshadowing a recession, as it is being heavily influenced by global central bank actions. The outlook for economic expansion in the first quarter remains relatively strong. According to the Atlanta Fed's GDPNow model, the estimate for real GDP growth in the first quarter is 3.2%, and the consensus forecast for all of 2018 is 2.7%. The outlook for continued economic expansion appears likely as 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. While the National Financial Conditions Index has backed off in recent months, it remains near levels that indicate financial conditions are their loosest since October 1994.
Based on the Fed's statements and its own interest-rate forecasts, as well as the heightened probability of rate increases priced into the futures market, it appears that short-term rates may continue to head higher in 2018. According to the CME FedWatch Tool, the probability that the Fed will lift rates to 1.50%-1.75% after its March meeting held steady at 83% compared with the prior week. In addition, the market expects further rate hikes through the rest of the year. The probability that the federal-funds rate at the end of 2018 will be greater than 1.75% is 91%, and the probability that it will be 2% or higher is 64%. After the March meeting, newly elected Fed Chairman Jerome Powell will conduct a press conference to make a statement and answer questions. The market will scrutinize his answers to try to divine any changes in his view of monetary policy compared with that of the prior chair. Investors will also be looking for any changes in the Fed's updated Summary of Economic Projections. According to the projections from the Fed's December 2017 meeting, the average federal-funds rate forecast of the board members is 2%, 2.70%, and 3% for the years ended 2018, 2019, and 2020.
Inflation expectations have risen thus far this year and are near the high end of their range of the past year. Currently, the 5-year, 5-year forward inflation expectation rate (market-derived expectation for average inflation for five years, beginning five years from today) is 2.16%, only 10 basis points higher than where it ended 2017. Since October 2016, the 5-year, 5-year forward inflation expectation rate has traded within 25 basis points of 2%.
While the Fed's monetary policy has directly affected short-term rates, the long end of the curve may also be influenced by the ongoing quantitative easing programs of the European Central Bank and Bank of Japan. With the 10-year U.S. Treasury yielding 2.87%, it is attractive to global bond investors, as the yield on Germany's 10-year bond is 0.65% and the yield on Japan's 10-year bond is 0.05%.
Outflows From Open-End High-Yield Funds Overwhelm High-Yield ETF Inflows
For the sixth consecutive week, net fund flows across high-yield open-end funds and exchange-traded funds remained negative. Total net high-yield fund flows registered an outflow of $0.2 billion for the week ended Feb. 23. Investors pulled assets out of high-yield open-end funds to the tune of $0.8 billion; however, for the first time since the beginning of January, high-yield ETFs registered $0.6 billion of net new unit creation. Historically, fund flows in the open-end mutual fund category has been a proxy for individual investor sentiment, whereas fund flows in the ETF space has been a proxy for institutional investors. Thus far this year, net redemptions in the high-yield asset class total $12.0 billion, which until this past week was relatively equally split between open-end funds and ETFs. Total outflow from the open-end mutual fund category is $6.1 billion and outflow from the ETFs is $5.9 billion.
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