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Credit Insights

While Equities Hit New Highs, Corporate Credit Spreads Tighten Only Slightly

Investors have been unwilling to pay up for corporate bonds.

Since the end of June, corporate credit spreads have tightened only slightly, even though U.S. stock market indexes have hit new highs. Thus far this month, the average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade corporate bond market) has tightened 4 basis points to +115. In the high-yield market, the ICE BofAML High Yield Master II Index tightened 5 basis points to +402.

Over the same period, equity markets have hit new highs. For example, the S&P 500 rose above 3,000 and increased 0.78% over the course of last week. While credit spreads typically would have tightened more in correlation to the strength in the equity markets, investors have been unwilling to pay up for corporate bonds as underlying interest rates have also risen off their lows. Month to date, the yield curve for U.S. Treasury bonds has risen between 9 and 12 basis points, with the long end of the curve rising the most.

As slowing global economic growth pressures the U.S. economy, investors would typically reallocate assets in their portfolios toward fixed-income products and away from the equity markets. The effect has historically been to boost bond prices and pressure the equity markets. However, over the past few months, global central bankers have been shifting toward easy monetary policies, which has caused the opposite effect. According to the CME FedWatch Tool, a rate cut is all but assured following the Federal Open Market Committee's July meeting. At the beginning of the year, the market was still pricing in the potential for one more rate hike in 2019; now investors expect the Federal Reserve to cut the federal-funds rate this summer and then two more times before the end of the year.

Currently there is a 76% market-implied probability of a 25-basis-point rate cut and a 24% chance of a 50-basis-point cut. Even after a rate cut in July, the market expects additional rate cuts before the year is over. The market-implied probabilities that the fed-funds rate will fall from its current range of 2.25%-2.50% to the following ranges following the December meeting are:

  • 11% for 2.00%-2.25%
  • 35% for 1.75%-2.00%
  • 37% for 1.50%-1.75%
  • 17% for below 1.50%

Recently released economic news and indicators have been relatively positive and indicate that while economic growth may have slowed in the second quarter, it should remain positive. For example, the increase in nonfarm payrolls in June of 224,000 was much stronger than consensus expectations, and the level of unemployment remains extremely low at 3.7%. While the low rate of inflation has long been one of the Fed's concerns, the June reading for the core constituents of the Consumer Price Index rose 0.3% in June, which pushed the annualized core CPI inflation rate up to 2.1% and the three-month annualized rate to 2.2%. In addition, the United States and China have agreed to a temporary truce and have halted the implementation of new tariffs while they return to the negotiation table. As of July 10, the GDPNow model estimate from the Federal Reserve Bank of Atlanta for the seasonally adjusted annual rate of real GDP growth in the second quarter is 1.4%. Even after accounting for these metrics, Fed Chairman Jay Powell's testimony to Congress last week was interpreted by the markets as confirming that the Fed is intent on hiking the fed-funds rate following the FOMC meeting July 30-31. Note that this meeting is not scheduled to release an updated Summary of Economic Projections. The next Summary of Economic Projections is scheduled to be released in conjunction with the Sept. 17-18 meeting.

The European Central Bank has also signaled its intentions to further ease its monetary policy. The ECB is reportedly considering cutting its already negative short-term interest rate, instituting additional bond-buying programs, and/or providing enhanced guidance that it could leave its short-term interest rate at a negative yield for even longer.

Weekly High-Yield Fund Flows
High-yield inflows are on a roll, posting their fifth consecutive weekly inflow. For the week ended July 10, high-yield inflows registered $0.5 billion. Inflows were weighted toward exchange-traded funds as net unit creation among high-yield ETFs rose $0.4 billion, while high-yield open-end mutual funds realized inflows of only $0.1 billion. For the week ended July 3, high-yield inflows registered $1.5 billion and were balanced between ETFs and open-end funds. Year to date, inflows into the high-yield asset class total $16.4 billion, consisting of $10.8 billion of net unit creation among high-yield ETFs and $5.5 billion of inflows across high-yield open-end mutual funds.

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