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Credit Insights

Just as Volatility Starts to Subside, It Ratchets Right Back Up

There are reportedly over $15 trillion worth of bonds currently trading at a negative yield.

Just when it appeared that volatility had started to subside, it kicked back up again at the end of last week. Compared with the wide daily market swings over the past few weeks, for most of last week the markets were trading in a much narrower range and corporate credit spreads were tightening steadily. However, in response to an escalation in the trade dispute between the U.S. and China on Aug. 23, the stock market sold off substantially and corporate bond markets weakened.

On the morning of Aug. 23, U.S. President Donald Trump announced he was going to retaliate against a new imposition of Chinese tariffs on $75 billion worth of U.S. products imported into China. That action was, in itself, a retaliation against earlier tariffs ordered by the U.S. In this most recent escalation, the president is raising the tariffs on $250 billion of imported Chinese products to 30% from 25% and increasing the tariffs to 15% from 10% on $300 billion of Chinese imports that is scheduled to begin on Sept. 1.

In the corporate bond market, credit spreads tightened steadily from Monday through Thursday, but gave back some of the gains on Friday as the S&P500 fell over 2.5%. In the investment grade market, on a week-over-week basis, the Morningstar Corporate Bond Index tightened 5 basis points to +123. In the high-yield market, the ICE BofAML High-Yield Master II Index tightened 22 basis points to +425. At these levels, both the investment grade and high-yield markets are trading near their average thus far this year.

In the U.S. Treasury bond market, the yield curve flattened during the week as the spread between the two- and 10-year U.S. Treasury bonds compressed. The yield on the two-year Treasury bond rose 4 basis points to 1.52%; whereas the yield on the 10-year decreased 2 basis points to 1.53%, thus resulting in only a 1-basis point spread between the two. The yield curve, and specifically the 2s10s curve, is closely watched by the markets because an inversion between these two points on the curve has historically been a precursor to an economic recession.

In mid-2018, while the yield curve was on a multi-year flattening trend and looked like it was going to invert, many economic prognosticators were expecting a near-term economic slowdown. However, at that time we said the yield curve may no longer have such a high predictive power to indicate a near-term recession as it had in the past. At that time most economic metrics remained strong and continued to indicate economic expansion. Over the past decade, interest rates have been significantly affected by the extremely loose monetary policies, negative interest rates, and quantitative easing programs instituted by most developed market global central banks such as the European Central Bank, or ECB, Bank of Japan, and Swiss National Bank. While the Federal Reserve had made a modest attempt to tighten monetary policy with a few rate hikes in the U.S., the ECB has maintained its short-term deposit rate at a negative yield (which was unheard of prior to the global financial crisis) and had instituted a quantitative easing program by purchasing both sovereign and corporate bonds in Europe.

Although interest rates in the U.S. may appear low to U.S. investors, the yields remain positive, which is attractive to global investors suffering from negative yields. According to Bloomberg, there are reportedly over $15 trillion worth of bonds that are currently trading at a negative yield. Currently, the yield on German five- and 10-year bonds are trading at a yield of negative 0.89% and negative 0.68%, just a few basis points from their historically most negative yields. The Swiss 10-year bond is trading at negative 0.93%, only a few basis points from its most negative yield historically, and the Japanese 10-year bond is trading at negative 0.23%, also only a few basis points above its all-time most negative yield. With most European sovereign debt trading at levels that guarantee a loss if held to maturity, global bond investors have increasingly looked to U.S. fixed income securities to generate a positive return. We have noted multiple times over the past few years, and even more often recently, the heightened demand from European and Japanese investors as reported by Wall Street bond traders for U.S. dollar-denominated fixed income securities.

Since the original concerns arose in mid-2018 that the yield-curve inversion was indicating a near-term recession, the U.S. economy has continued to expand, albeit at a modest rate. However, the inversion of the yield curve may be a different story this time. Compared with mid-2018, many economic indicators have slipped and are indicating a mixed bag as some continue to indicate economic expansion and some are beginning to indicate economic contraction. For example, Markit’s composite Purchasing Managers Index fell to 50.9 from 52.6 in July. Within the composite index, the underlying manufacturing component fell to 49.9 in August from 50.4 in July and the services component fell to 50.9 from 53.0 in July. While the composite index continues to indicate economic expansion because readings above 50 indicate economic growth, the trend has been decidedly negative.

Last Friday, Federal Reserve Chair Jerome Powell gave a speech at the Federal Reserve’s annual conference at Jackson Hole, Wyoming. This event is closely monitored by the markets because it has often provided the Fed with a public venue to communicate its views on economic expectations and potential responses to changing economic conditions. In his remarks, he said the downside risks to continued economic expansion have increased over the past three weeks. These comments were interpreted to mean the Fed will continue to ease money policy to try bolster the economy. According to the CME FedWatch Tool, the market is pricing in an 81% probability of a 25-basis point cut and a 19% probability of a 50-basis point cut to the federal funds rate after the Fed’s September meeting with additional cuts priced in after the December meeting.

In addition to the weakening among fundamental economic indicators, the potential for global political risks to further exacerbate economic weakness have increased. For example, the effect of a no-deal Brexit of the U.K. from the European Union or the effect from the collapse of the current Italian government could further pressure European economies. If the ongoing protests in Hong Kong were to intensify and exacerbate the weakness in the Chinese economy, contagion could spread to other southeastern Asian countries. In South America, Argentina’s currency and sovereign bonds tumbled earlier this month after a preliminary vote for populist presidential candidate Alberto Fernández and his vice-presidential running mate Cristina Fernández showed surprising strength heading into the October general elections. Both Argentinean bonds and the currency are pricing in a significantly higher probability of default if the Fernández ticket were to oust the business-friendly existing government of Mauricio Macri. Since that vote, the Argentinian peso has fallen about 18% compared with the U.S. dollar.

After experiencing the third greatest outflow over the past year three weeks ago, it appeared fund flows had stabilized two weeks ago after fund flows returned to positive territory. However, that respite was short-lived because investors decided the volatility in the markets was more than they could handle and withdrew $1.6 billion from the high-yield asset class last week. The outflows were comprised of $1.2 billion of net unit redemptions across the high-yield exchange-traded funds, or ETFs, and $0.4 billion of withdrawals from the open-end mutual funds.

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