Assets Rise as Global Monetary Policy Gets Even Easier

The markets reacted favorably to the European Central Bank's intimation that it would ease monetary policy further in December and the People's Bank of China's announcement that it had cut its benchmark rates. The average spread of the Morningstar Corporate Bond Index tightened 5 basis points to +172 bps over Treasuries, and the average credit spread in the Bank of America Merrill Lynch High Yield Master Index tightened 21 basis points to end the week at +597. The equity market reacted even more favorably as the S&P 500 rose 2.1%, returning to positive territory for the year. Year to date, our investment-grade index has risen 0.89% and the high-yield index has risen 0.22%

China Cuts Rates; ECB Hints at Easier Euro to Come As global economic activity limps along, global central banks are trying to force even more liquidity into the markets in an attempt to spur economic growth.

On Friday, China announced that its central bank cut each of its benchmark lending and deposit rates by 0.25%. The PBOC also reduced its reserve requirement ratio (the amount of capital that banks need to reserve against loans) by 0.50%. This action piles on top of the other easing steps the PBOC has taken over the past year. This reduction is the sixth time since last November that the PBOC has lowered its benchmark lending rate and the fourth time it has lowered the reserve requirement ratio.

Earlier in the week, China reported that its third-quarter GDP growth rate had slowed to 6.9%. While that would be the envy of any developed economy, it is slowest rate of increase in China since early 2009—during the midst of the global financial crisis. The 6.9% growth rate is not much below the 7.0% growth rate targeted by policymakers and the rate achieved in the first half of the year; however, based on other economic metrics, many pundits had thought that the growth rate would have been even slower. Considering how much monetary easing the PBOC has already initiated over the past year and how quickly it reacted after the GDP report was released, we suspect Chinese policymakers are more concerned about deceleration in economic growth than a 0.1% decrease would otherwise warrant.

On Thursday, the European Central Bank announced that it had left its monetary policy unchanged this month. Currently, the interest rates on the main refinancing operations, marginal lending facility, and deposit facility are 0.05%, 0.30%, and negative 0.20%, respectively. However, ECB President Mario Draghi said the ECB would evaluate easing monetary policy further at its December meeting, strongly intimating that it would expand its existing program. He said, "The degree of monetary policy accommodation will need to be re-examined at our December policy meeting." Currently, the ECB is less than halfway into the quantitative-easing program it began earlier this year. The program entails the purchase of an average EUR 60 billion of bonds every month for 18 months, which will result in EUR 1 trillion of asset purchases.

Sovereign bonds in Europe traded higher last week, pushing their yields down toward historical lows. For example, the 10-year German bund ended the week at 0.51%, the Italian 10-year at 1.50%, and the Spanish 10-year at 1.64%. In addition, shorter-duration bonds are trading at negative yields. For example, the 5-year German bund ended the week at negative 0.10%. As investors look for a safe haven to shelter their assets from further depreciation, the price on the Swiss 10-year bond (which is denominated in the Swiss franc) has risen so high that the yield reached an all-time low of negative 0.29%.

Considering that interest rates are already at historical lows, it is highly unlikely that even lower interest rates will stoke the flames of new economic growth. However, the low interest rates will probably help to drive asset prices higher. Unfortunately for most Europeans, stocks and bonds are not as widely owned by individuals as in the United States, which will mute the impact of the wealth effect. The other asset class that will benefit from low long-term rates is real estate. This in turn will help to increase the collateral value that the European banks lent against before debt crisis. As the collateral value securing banks' loan books declined over the past few years, banks have been especially wary of making new loans or refinancing existing loans. As the value of the real estate appreciates, it will allow the banks to roll over loans that otherwise may not have had enough collateral value to refinance. This should help to bolster the banks' balance sheets, improve recovery values for loans that do end up in default, and increase credit availability in the eurozone.

With interest rates already near historical lows, it appears that the other intent of easing monetary policy even further is to debase the currency in order to import inflation from across the world. Further monetary easing through an increase in the average monthly purchase target, lengthening the program, and/or lowering rates even further (or making them more negative as the case may be) will push the value of the euro down against other currencies, including the U.S. dollar. Traders jumped on the news last week and pushed the euro/dollar exchange rate down 3%. Since October 2014, the exchange rate has fallen more than 13%. The strengthening dollar will make U.S. exports increasingly uncompetitive compared with goods and services denominated in the euro. Some forecasters have projected that the euro/dollar exchange rate could fall to 0.95, some 16% lower than where it stood before the ECB meeting.

The Bank of Japan is in the midst of its own monetary easing program and is rumored to be looking to ease its policy even further. As the dollar strengthens against other global currencies, it places more pressure on the Federal Reserve to refrain from raising rates in the U.S., lest raising rates further strengthen the dollar and make exports even more uncompetitive on the world stage. The markets have all but priced in that the Fed will not raise rates in October or December. Considering there is no press conference in conjunction with the January meeting, it is highly unlikely that the Fed will raise rates until March 2016. Following the March meeting, the next Federal Open Market Committee meeting with a press conference and economic projections is in June 2016, when the presidential election campaigns will be in full force.

Impact of Further Monetary Easing on the Corporate Bond Markets Interest rates on European fixed-income securities are much lower than in the U.S. If the ECB does ratchet up its asset purchases, it will probably inhibit interest rates from rising in the U.S. and may even pull U.S. interest rates down further. For example, the yield on the 10-year U.S. Treasury is currently 2.08%, more than 150 basis points higher than the 10-year German bund. U.S. Treasury bonds offer global investors a significant yield pickup over sovereign European debt and the safety of being denominated in U.S. dollars. By purchasing dollar-denominated assets, if the euro exchange rate continues to slide, investors will benefit from enhanced purchasing power when they convert their investments back into euros. In addition, the creditworthiness of the U.S. is still multitudes higher than that of BBB rated Italy and Spain, yet the yield on U.S. bonds is higher than both of those countries.

With interest rates on sovereign bonds in developed markets at such low rates, corporate bonds should perform well on a relative basis. As the ECB purchases sovereign debt and asset-backed securities, the proceeds will need to be reinvested somewhere, and the path of least resistance will be the corporate bond market. This demand is likely to drive corporate credit spreads tighter. As corporate credit spreads in Europe contract, this will naturally pull credit spreads tighter in the U.S. Investors who can purchase debt in either euros or dollars will gravitate toward the debt that offers both greater spread and a higher all-in yield, which is currently U.S. dollar-denominated debt.

Performance of corporate bonds in sectors will probably be bifurcated in the near term. The sectors that will perform the best will be those not exposed to low oil prices or basic material commodity prices (such as iron ore, coal, and copper). Bonds in the basic materials and energy sector currently offer the highest spreads for their rating, but unless commodity prices recover substantially in the next few months, we expect downgrades and defaults in these sectors will pick up next year. Most exploration and production companies have hedged enough of their 2015 production to make it through this year; however, as their hedges begin to expire, those E&P companies with higher break-even costs on a per barrel of oil basis will start to default in 2016. These defaults could pressure the entire energy sector and force spreads to widen even further, especially as the value of oil fields will be depressed and recovery values will be slim. As such, many portfolio managers have positioned themselves to be neutral or slightly underweight the energy sector.