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Credit Insights

Demand Dwindles for Corporate Bonds After Tariff Declaration

Last week started off strong as investors were emboldened by the Federal Reserve's impending pivot toward easing monetary policy. Equity prices surged to new highs, corporate bonds were in high demand, and commodity prices moved up. In the corporate bond markets, the new issue market was especially active as issuers looked to lock in funding before portfolio managers head to the beach during the typical seasonal slowdown in August.

As expected, on Wednesday the Federal Reserve cut the federal-funds rate 25 basis points to 2.00%-2.25%, the first cut since the depths of the global financial crisis at the end of 2008. However, in a rare display of contention on the Federal Open Market Committee, two voting members (presidents of the Boston and Kansas City Federal Reserve Banks) dissented from this action. Once the markets digested this information Wednesday afternoon, prices for risk assets began to fall, corporate bond credit spreads widened, and U.S. Treasury prices rose. The markets had been pricing in additional cuts to the fed-funds rate through the end of this year, but two voting members dissenting on this first cut called into doubt the assumption of additional near-term easing, and many traders feared that the Fed might be one-and-done for the foreseeable future. Without the prospect of additional near-term monetary easing, many traders decided to sell and lock in some of the gains they have made thus far this year.

The corporate bond and equity markets began to recover lost ground Thursday but reversed course after President Donald Trump announced his intention to impose 10% tariffs on $300 billion worth of imports from China. After a brief cease-fire, the resumption and expansion of the trade war renewed fears that the United States will not be able to stave off contagion from the economic malaise that has been spreading in Europe and Asia. After declining Wednesday afternoon, the market-implied probability of another rate cut jumped to 95% from 61%. Between the concerns that economic growth will be hampered by the trade war and the assumption that the Fed will be forced to ease monetary policy in the second half, U.S. Treasury bond prices soared and pushed yields down to multiyear lows. For example, the yield on the 2-year dropped 17 basis points to 1.68% and the yield on the 10-year declined 13 basis points to 1.89%. At this interest rate, the 10-year Treasury is trading at its lowest level since before the 2016 election.

Following the 2016 election, interest rates had been on an upward trend as pro-growth policies, tax cuts, and reduced regulations helped spur economic growth. While those initiatives bolstered economic growth over the past two years, their impact has been dwindling on a sequential and year-over-year basis. Coincident and lagging economic metrics have remained solid, but some leading economic indicators have recently shown signs of possible weakness. For example, the report for nonfarm payrolls and average hourly wages released last week indicated a solid employment environment; unemployment held steady at 3.7%, near its 50-year lows. However, these economic metrics have historically been more correlated with the economy as either coincident or lagging economic metrics. Other economic reports such as survey reports, which have a higher correlation to leading economic indicators, such as the PMI Manufacturing Index and ISM Manufacturing Index, have been on a downward trend. Both metrics continue to register above 50, which is the demarcation between economic growth and contraction, but both have been on a multimonth decline. According to the Atlanta Federal Reserve Bank's GDPNow model estimate, economic growth for the third quarter is running at a 1.9% pace compared with the 2.1% annualized rate reported for the second quarter and 3.1% for the first quarter.

Between the weak economic survey reports and the imposition of new tariffs, oil prices fell $1 per barrel to $55.34 and copper fell almost 5% to $2.57 a pound last week, its lowest price over the past two years. Because of copper's myriad uses in new construction, consumer products, and electronics, its demand and pricing is considered to be a bellwether for economic expectations. The impact from falling oil prices and lower commodity prices will be to lower the rate of inflation as those lower prices work their way through the economy and provide the Fed with an additional reason to continue to ease monetary policy.

The strong investor demand that had been driving corporate credit spreads tighter this year dried up, and fixed-income traders sought refuge in safe-haven assets such as U.S. Treasury bonds. In the investment-grade market, the average spread of the Morningstar Corporate Bond Index widened 6 basis points to +117 last week. In the more volatile part of the fixed-income world, the high-yield market, as measured by the ICE BofAML High Yield Master II Index, credit spreads gapped wider by 30 basis points to an average credit spread of +419.

Corporate bond markets have realized outsize gains this year as the combination of declining interest rates and tightening credit spreads has driven bonds prices higher. Thus far this year, the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) has risen 9.99% and the ICE BofAML High Yield Master II Index has increased 10.30%.

Year to date, credit spreads have tightened 40 basis points in the investment-grade market and 114 basis points in the high-yield market. However, while credit spreads have tightened significantly more in the high-yield market, the return for investment-grade bonds has mostly kept pace with the high-yield market. The investment-grade bond index has a much longer duration than the high-yield index, and the decline in underlying interest rates has driven a significant amount of its return. The deceleration in economic growth and expectation that the Fed will cut the federal-funds rate even further has driven interest rates to multiyear lows. Year to date, the interest rates on 2-, 5- 10-, and 30-year bonds have fallen by 78, 85, 83, and 63 basis points, respectively, to 1.71%, 1.66%, 1.85%, and 2.38%.

Not only are interest rates hitting multiyear lows in the U.S., but interest rates in Europe are hitting new lows, or in many cases trading at even greater negative yields. Between weakening economic growth in the European Union and the heightened potential for a no-deal Brexit, investors expect the European Central Bank will pursue even more extreme monetary policies later this year in an attempt to bolster EU economies. Prices on German bonds continued to surge higher last week and pushed yields even deeper into negative territory. The 5- and 10-year German bonds ended the week at their historically most negative yields of 0.74% and 0.50%, respectively. Spain's 10-year bonds hit a record-low rate of 0.25%.

Weekly High-Yield Fund Flows
High-yield inflows continued their winning streak, posting their eighth consecutive weekly inflow last week. According to our data, this is the first time since October 2013 that inflows have registered eight consecutive weekly inflows. For the week ended Wednesday, high-yield inflows registered $0.5 billion. Inflows were split between $0.3 billion of net new unit creation across high-yield exchange-traded funds and $0.2 billion of inflows among high-yield open-end mutual funds.

Year to date, inflows into the high-yield asset class total $18.66 billion, consisting of $12.5 billion worth of net unit creation among high-yield ETFs and $6.1 billion of inflows across high-yield open-end mutual funds.

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