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Credit Insights

Federal Reserve’s Dovish Shift Surprises Bond Market

The Federal Reserve surprised the markets with its shift toward a dovish monetary posture. Based on its latest projections released last week in conjunction with the March statement of the Federal Open Markets Committee, the Fed acknowledged that economic growth has slowed since the fourth quarter, lowered its economic forecasts, and indicated that it will not hike the federal-funds rate any further this year. As recently as December 2018, the Fed had indicated that it expected to raise interest rates twice in 2019. In addition, the Fed announced that in September, it will discontinue the run-off of its balance sheet.

While the shift may have surprised many traders, the changes in the Fed’s monetary posture were quickly absorbed in the interest-rate futures market. According to the CME’s FedWatch Tool, the market-implied probability that the federal-funds rate would remain unchanged through the end of 2019 plunged to only 44% from 70% just one week ago and 89% one month ago. The probability of one rate cut jumped to 39% from 26% last week and 11% a month ago. The probability of two or more rate cuts increased to 17% from 7% last week and less than 1% a month ago.

After the release of the FOMC statement, U.S. Treasury bond prices and equity markets immediately surged higher; however, while U.S. Treasury bonds continued their rally through Friday, the equity markets retreated after investors reconsidered that the reason for the Fed's more dovish stance was softening economic expectations. As bond prices rallied, interest rates declined across the entire yield curve. By the end of the week, the rate on 2-, 5-, 10-, and 30-year bonds fell by 12, 16, 15, and 14 basis points, respectively. At these levels, interest rates are as low as or closing in on, they have been, since the beginning of 2018. In the equity market, after all of the volatility, once the smoke cleared at the close of the market on Friday, the S&P 500 had fallen 0.77% for the week. 

Numerous other economic metrics and indicators are also pointing toward an economic slowdown this quarter. Although the GDPNow model estimate by the Federal Reserve Bank of Atlanta for first-quarter 2019 GDP rose to 1.2% from 0.4%, that would still be a significant slowdown from the 2.6% growth rate in the fourth quarter of 2018 and 3.4% growth rate in the third quarter. The Purchasing Managers Index released on Friday dropped to 54.3 from 55.8, as both the manufacturing and services sectors fell. However, while the drop was a significant miss from Street expectations, which only forecast a slight decline, it is not as dire as one might be led to believe, as a reading above 50 continues to indicate expansion, just at a slower growth rate than expected. The market is also keeping a close eye on the yield curve. At 11 basis points, the spread between the 10-year and 2-year Treasury has narrowed to its tightest level since the curve was inverted in 2007, just before the beginning of the last recession and advent of the global financial crisis. In fact, there are several parts of the credit curve that have inverted, as the 5-year Treasury bond is trading at 2.24%, the lowest yield across all of the major benchmark bonds.

A similar trading pattern occurred across many of the global markets, as sovereign bonds traded up and equities sold off. In Germany, the yield on its 10-year bond traded back down into negative territory, ending the week at negative 0.02%, the first time its traded below zero since the fall of 2016. Among the European equity indexes, Germany’s DAX index dropped 2.75% and the French CAC fell 2.50%.

Corporate Bond Market Update
Corporate bonds traded in a relatively narrow range, with a slight tightening bias for most of last week but gave back some of the gains on Friday in conjunction with the plunge across the equity markets. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade corporate bond market) held most of its gains and tightened 2 basis points to +122, whereas, in the high-yield market, the average spread of the ICE BofAML High Yield Master II Index widened 8 basis points to +403.

Year to date, both the investment-grade and high-yield markets have recovered a significant amount of the widening that occurred late last year. Thus far this year, investment-grade corporate bond spreads have narrowed by 35 basis points and high-yield spreads have tightened 130 basis points.

Between the rally in underlying benchmark interest rates and tightening credit spreads, fixed-income indexes have performed well this year. Through March 22, the Morningstar Corporate Bond Index has risen 4.06% and the ICE BofAML High Yield Master II Index has risen 6.95%. Comparatively, in the equity markets, the S&P 500 has risen 11.73%.

Recent Morningstar Credit Ratings Research
Following the announcement that Biogen Inc (A, stable) and its partner Eisai Co., Ltd (not rated) discontinued late-stage clinical trials for aducanumab, Morningstar Credit Ratings published a note outlining our rationale on why we believe that the news will not affect our credit rating. The trials were investigating the efficacy and safety of the Alzheimer’s drug candidate but were halted based on results of a futility analysis conducted by an independent data monitoring committee that indicated the trials were unlikely to meet their primary endpoint upon completion.

We look to Biogen’s research and development pipeline as a means to reduce dependency on its multiple sclerosis drug portfolio and expect rising portfolio diversity to stem from rapid uptake of newer medicines. With the termination of the drug project, greater emphasis is placed on successful commercialization of a relatively thin late-stage pipeline. Considering the unfavorable news, our revenue and EBITDA growth estimations turned from slightly positive to stagnant. However, we still expect the firm to be highly cash-generative, with annual free cash flow averaging more than $4 billion through 2023, which helps hold the presently strong Cash Flow Cushion and very strong Solvency Score pillars. For the full credit note, please visit: Biogen (A, Stable) Discontinues Key Research Pipeline Program; Credit Ratings Unaffected, published March 21, 2019.

Weekly High-Yield Fund Flows
For the week ended March 20, net high-yield fund inflows were $1.6 billion. Fund flows were relatively balanced, as there were $0.9 billion of inflows into the open-end high-yield mutual funds and $0.7 billion of net unit creation among the high-yield exchange-traded funds.


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