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Credit Insights

Pavlov's Markets Salivate at Sound of Impending Rate Cuts

ECB and Fed are signaling a shift toward an easy monetary policy.

Prices rose across all financial markets, all asset classes, and all over the world last week, spurred by global central banks' shift toward easy monetary policies. The rally began Tuesday, after European Central Bank President Mario Draghi publicized that the ECB was considering instituting new stimulus programs in July. These could include a cut in the ECB's already negative short-term interest rate, additional bond-buying programs, and/or additional guidance that the central bank could leave its short-term interest rate at a negative yield even longer. The rally then picked up steam after the U.S. Federal Reserve intimated that it too was shifting toward an easy monetary policy.

According to the CME FedWatch Tool, a rate cut is all but assured following the Federal Open Market Committee's July meeting. Currently there is a 67% market-implied probability of a 25-basis-point rate cut and a 33% chance of a 50-basis-point cut. Even after a rate cut (or two) in July, the market is expecting additional rate cuts before the year is over. Following the December meeting, the market-implied probabilities that the fed-funds rate will fall from its current range of 2.25%-2.50% to the following ranges are:

  • 6% for 2.00%-2.25%
  • 28% for 1.75%-2.00%
  • 39% for 1.50%-1.75%
  • 27% for below 1.50%

As investors priced in new stimulus programs and lower short-term interest rates, prices on global sovereign bonds soared. In the United States, the yields on Treasury bonds (which have already fallen substantially thus far this year) continued to decline. On Thursday, the yield on the 10-year Treasury bond briefly broke though the 2.00% psychological floor before bouncing slightly to end the week at 2.05%. The last time the 10-year traded below 2.00% was in November 2016, a few months after the Brexit vote in the United Kingdom sent global markets into turmoil.

In Europe, negative interest rates continue to rule the markets. Germany's 5- and 10-year bonds were unchanged at negative yields of 0.63% (a new low) and 0.29% (also a new low). Even the interest rates on lower-quality sovereign bonds rallied and, in some cases, also hit new lows. The yield on Italy's 10-year bond fell to 2.15% and the interest rate on Spain's 10-year bond fell to a new low of 0.44%. Both of these countries' 10-year bonds were trading over 6% in 2011 as the markets were pricing in heightened sovereign and European bank default risk following the Greek default; it took the institution of the ECB's asset-purchase program to stem the decline in those countries' bond prices.

In the corporate bond markets, investors snatched up any offers they could find and were willing to pay up to source paper. The average credit spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade corporate bond market) tightened 9 basis points to +121. In the high-yield market, the ICE BofAML High Yield Master II Index tightened 28 basis points to +395.

In the equity markets, the S&P 500 rose 2.20% last week and has risen 17.70% year to date. It was a similar story in Europe as Germany's DAX rose 2.01% and France's CAC increased 2.99%. Thus far this year, these two indexes have gained 16.87% and 16.86%, respectively. Even the ongoing trade dispute between the U.S. and China could not dissuade investors from bidding up the price of Chinese stocks. The Shanghai Composite Index rose 4.16% last week and has increased 20.37% year to date.

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 5.62%. A significant portion of this return can be attributed to the increase in bond prices as interest rates have fallen across the yield curve. Since the end of last year, the yields on the 2-year and 10-year Treasury bonds have fallen by 72 and 63 basis points, respectively. In the corporate bond market, indexes have been bolstered by tightening corporate credit spreads. For example, even after spreads widened in May, year to date the average spread of the Morningstar Corporate Bond Index has tightened 36 basis points and the ICE BofAML High Yield Master II Index has tightened 138 basis points. Thus far this year, our investment-grade corporate bond index has risen 8.95% and the ICE BofAML High Yield has increased 10.14%.

While the markets are convinced that the Fed will begin to ease monetary policy next month, based on recent economic metrics, economic growth in the second quarter may not have slowed as much as suspected. For example, as we noted last week, May retail sales grew 0.5% month over month and the April sales report was revised higher by 0.5%. Based on these levels, consumption growth is projected to increase by 4% on an annualized basis in the second quarter. Currently, the Atlanta Federal Reserve Bank's GDPNow model estimate for the seasonally adjusted annual rate of real GDP growth in the second quarter is 2.0%, near the highest level the projection has registered this quarter and a substantial increase from the reading below 1% at the beginning of May.

Weekly High-Yield Fund Flows
For the week ended June 19, high-yield inflows into exchange-traded funds and open-end mutual funds were $0.5 billion. All of the inflows were concentrated in ETFs as fund flows in the open-end space were unchanged. Considering the market action in the latter half of last week, we suspect that high-yield fund inflows picked up pace on Thursday and Friday.

Year to date, inflows into the high-yield asset class total $11.3 billion, consisting of $7.8 billion worth of net unit creation among high-yield ETFs and $3.5 billion of inflows across high-yield open-end mutual funds. Yet, while inflows have been strong for most of this year, over the past 52 weeks, the high-yield market has still not recovered all of the outflows from the fourth quarter of 2018. Including the outflows registered late last year, over the past 52 weeks, total outflows equal $5.1 billion. Net redemptions were driven by $7.2 billion of withdrawals across open-end mutual funds, which were only partially offset by $2.1 billion of net unit creation among high-yield ETFs.

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