U.S. Markets Yawn in Response to Italian Sovereign Debt Market Turmoil
Prices for Italian sovereign bonds dropped precipitously across the board.
Asset markets in the United States yawned in reaction to turmoil in the European asset markets last Friday, as U.S. corporate bond credit spreads and equity prices were relatively unchanged. Prices for Italian sovereign bonds dropped precipitously across the board following Italy's announcement that its budgeted deficit for 2019 would breach the European Union's limit. Currently, Italy's debt/GDP ratio is the second highest in the EU, surpassed only by long-beleaguered Greece. As bond prices fell, the yield on Italy's 2-year bonds rose 25 basis points to 1.01%. In the longer end of the curve, the yield on Italian 10-year bonds rose 26 basis points to 3.14%. By comparison, Germany's 2-year bond still trades at a negative yield of 0.52%, and German 10-years trade at 0.47%. As an indication of the market's perception of Italian default risk, the current spread between Italian and German debt has widened to 267 basis points. The current rates for Italian sovereign debt rival the highest interest rates the bonds have traded at since mid-2014, when the bonds were recovering from the Italian banking crisis. Contagion from this dramatic freefall in the sovereign bond market spread to the equity prices of Italian banks, which fell on average 5.3% and in turn led to a 3.7% decline in the FTSE MIB Index. Germany's DAX dropped 1.52%, France's CAC declined 0.85%, and Spain's IBEX fell 1.45%.
The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) was unchanged last week at +110. In the high-yield market, the BofA Merrill Lynch High Yield Master Index tightened 1 basis point to +324. While investment-grade bonds still have a ways to go before getting back to the tight levels registered earlier this year, spreads in the high-yield market remain at their narrowest levels of the year, which is also the tightest that they have traded since before the 2008-09 global financial crisis.
The yield on the 2-year Treasury rose 2 basis points to 2.82% last week; however, the rest of the curve was essentially unchanged with the 5-, 10-, and 30-year Treasury bonds ending the week at 2.95%, 3.06%, and 3.21%, respectively. As expected, the Federal Open Market Committee hiked the target range of the federal-funds rate by a quarter percentage point to 2.00%-2.25% following its September meeting. According to the CME FedWatch Tool, the market is pricing in a 79% probability of an additional quarter-point hike following the December FOMC meeting. According to market pricing, the Federal Reserve will have at least one more rate hike in store for 2019 and possibly two. The futures market is pricing in a 79% probability that the federal-funds rate will end 2019 at 2.50% or higher and a 44% probability that it will be 2.75% or higher.
After running at a gangbusters rate for the first three weeks of the month, the pace of new issues slowed dramatically last week as portfolio managers concentrated on quarter-end rebalancing in the secondary market and issuers looked to close up their books for the third quarter. However, even with the month ending on a quiet note, Bloomberg reported that September was the busiest month for pricing new issues thus far this year. Other than a possible deal or two to fund near-term M&A buyouts, the pace of new issues in the beginning of October will probably be sluggish as companies enter their quiet periods before earnings announcements. The pace should pick up by the end of the month as companies look to lock in financing before the holiday season beings in the second half of November.
Weekly High-Yield Fund Flows
Volatility among high-yield fund flows may be re-emerging after a multiweek hiatus. The total amount of net outflows was $1.7 billion, consisting almost entirely of net unit redemption among high-yield exchange-traded funds as the amount of outflows among high-yield open-end mutual funds was only $0.1 billion. Typically, fund flows among exchange-traded funds have been considered to be indicative of institutional investor demand, whereas fund flows in open-end high-yield funds are representative of individual investor demand. Year to date, fund flows have registered a total outflow of $16.5 billion, consisting of $4.1 billion of net unit redemptions across ETFs and $12.4 billion of redemptions among open-end funds.
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