Credit Insights

Stocks Regain Lost Ground, but Corporate Bond Market Fails to Follow

Dave Sekera, CFA

Last week, the markets were mainly focused on commentary from Federal Reserve Chairman Jerome Powell and the public back and forth between the Trump administration and the Chinese government. The stock market soared higher midweek following Powell's intimation that the federal-funds rate is closing in on what the Fed considers to be a neutral rate. The neutral rate is the theoretical interest rate at which short-term rates are neither stimulative nor restrictive to future economic growth and inflation. Later in the week, the positive momentum continued to propel the stock market higher as investors became more confident that the United States and China will be able to negotiate reasonable trade terms and tariffs, despite the ongoing posturing. The preponderance of the stock market's gains occurred Wednesday following Powell's public commentary, leading the market to a 4.85% increase over the course of the week.

While the equity markets rose, the corporate bond market continued to operate in a risk-off mode. The average spread of the Morningstar Corporate Bond Index (our proxy for the investment-grade market) widened 6 basis points to end the week at +143. In the high-yield market, the BofA Merrill Lynch High Yield Master Index ended the week unchanged at +429. While the equity market has generated gains thus far this year, the average spread of the investment-grade index has widened 47 basis points and the credit spread of the high-yield index has risen 66 basis points year to date. The decline in oil prices has weighed heavily on the energy sector, whose bond prices have plunged lower across the board and have had an outsize impact on the overall corporate bond indexes.

From their recent highs in early October, oil prices have fallen about 30% to $50.93 per barrel at the market close last Friday. Over that same period, the average spread of the energy sector in the Morningstar Corporate Bond Index widened 50 basis points to +184, and the energy component of the high-yield index widened 200 basis points to +557.

Economic metrics released last week reflected ongoing economic growth. For example, consumption increased 0.4% in October on a month-over-month basis, which indicates that consumption growth in the fourth quarter may be in excess of 3.0% on an annualized basis. According to the Atlanta Fed's GDPNow model, fourth-quarter GDP growth is on track to be 2.6% on an annualized basis. While this is a decrease from the economic growth rate posted in the third quarter, according to the CME's FedWatch Tool, the market-implied probability that the Federal Reserve will hike the federal-funds rate following the Federal Open Market Committee meeting this month by another quarter point rose to 83% from 76% at the end of the prior week. The market is more confident about this rate hike occurring, but following Powell's commentary, the market-implied probabilities of additional rate hikes in 2019 have declined. The market-implied probability that the federal-funds rate would end 2019 at 2.50% or higher declined to 77% from 88% at the beginning of November, and the probability that the fed-funds rate would be 2.75% or higher fell to 38% from as high as 59% at the beginning of November.

In the U.S. Treasury bond market, the yield on the 2-year U.S. Treasury bond declined 2 basis points to 2.79%, and the yield on the 5-year fell 6 basis points to 2.81%. In the longer end of the curve, the 10-year declined 5 basis points to slip just below 3.00%, and the 30-year decreased 1 basis point to 3.29%. The spread between the 2-year and the 10-year decreased to 6 basis points to +20. While interest rates have compressed slightly over the past few weeks, interest rates remain much higher year to date across the entire yield curve. The interest rates on the 2-, 5-, 10-, and 30-year Treasuries have risen 91, 60, 58, and 55 basis points, respectively.

In the European sovereign bond markets, Italian bond prices soared as investors were comforted after the Italian government changed its stance on its 2019 budget deficit target and said it was ready to compromise with the European Union. The yield on Italy's 10-year ended the week at 3.21% after peaking at 3.70% in mid-October when investors were concerned that the disputes regarding Italy's forecast budget deficit for 2019 could prompt a resurgence in the European sovereign crisis.

Weekly High-Yield Fund Flows
Net fund outflows were $1.3 billion last week. Among open-end high-yield funds, investors withdrew $0.6 billion, and across high-yield exchange-traded funds, net unit redemptions totaled $0.7 billion.

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