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Credit Insights

Bond Markets Rally as Investors Price In Monetary Easing

Fixed-income markets rallied across the board last week as investors bid up the prices for global sovereign bonds. The confluence of slowing economic growth, ongoing trade negotiations, and weakening employment led investors to price in a significantly higher probability that the U.S. Federal Reserve will begin to ease monetary policy in the near term. According to the CME FedWatch Tool, the probability that the Fed will lower the federal-funds rate in June rose to 25% and the probability of a rate cut in conjunction with the July meeting rose to 87%. Even after an expected rate cut this summer, investors don't think the Fed will stop at just one. The probability that the Fed will cut rates at least three times by the end of 2019 is slightly over 50%.

Economic growth has been slowing over the past few months. Based on current economic indicators, the Atlanta Federal Reserve Bank's GDPNow model estimate for the seasonally adjusted annual rate of real GDP growth in the second quarter dropped to 1.4%. The reading had been as high as 1.7% as recently as the beginning of May. With the economy softening, companies have been reducing the rate of hiring, and the employment report for May dropped to 75,000, the weakest reading since mid-2009.

As prices on Treasury bonds and other high-quality sovereign bonds rose, interest rates fell across the world, in some cases to all-time lows. In the United States, the yield on short- to medium-duration bonds fell, and by the end of the week, the 2-, 5-, 10-, and 30-year closed at 1.85%, 1.85%, 2.08%, and 2.57%, respectively. These are the lowest yields at which Treasuries have traded since 2017. In Europe, negative interest rates were not enough to dissuade investors from flocking to Germany's sovereign bonds as prices rose enough to push Germany's 5-year bond to an even greater negative yield of 0.60% (only 2 basis points from its prior low) and the yield on the 10-year bond declined to negative 0.26% (a new low).

After steadily widening out for the past few weeks, corporate credit spreads stabilized and began to reverse course. In the investment-grade market, investors remained cautious; the average credit spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade corporate bond market) tightened only 1 basis point to +131. In the high-yield market, however, the ICE BofAML High Yield Master II Index tightened 22 basis points to +437.

Year to date, fixed-income indexes have produced outsize gains compared with the amount of yield carry that bonds would have generated alone. For example, the Morningstar Core Bond Index (our broadest measure of the overall fixed-income market) has risen 5.14%. A significant portion of this return can be attributed to the increase in bond prices as interest rates have fallen across the yield curve. In the shorter end of the curve, since the end of last year, yields on the 2-year and 10-year Treasury bonds have fallen 64 and 60 basis points, respectively. In the corporate bond market, indexes have been further bolstered by tightening corporate credit spreads. For example, even after spreads widened in May, the average spread of the Morningstar Corporate Bond Index has tightened 26 basis points and the ICE BofAML High Yield Master II Index has tightened 96 basis points. Thus far this year, the Morningstar Corporate Bond Index has risen 7.67% and the ICE BofAML High Yield has increased 8.57%.

Weekly High-Yield Fund Flows
For the week ended June 5, investors pulled $2.6 billion out of the high-yield asset class. Outflows were led by withdrawals of $1.4 billion from high-yield open-end mutual funds, which were nearly matched by $1.2 billion of net unit redemptions across high-yield exchange-traded funds. This is the second-largest weekly withdrawal from the high-yield sector this year and the fourth-largest weekly withdrawal over the past 52 weeks.

Year to date, inflows into the high-yield asset class total $9.2 billion, consisting of $6.0 billion worth of net unit creation among high-yield exchange-traded funds and $3.2 billion of inflows across high-yield open-end mutual funds. Including the outflows registered late last year, over the past 52 weeks, total outflows equal $7.1 billion, with $7.5 billion of withdrawals across open-end mutual funds partially offset by $0.4 billion of net unit creation among high-yield ETFs.

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