11/14/2017
The widening yield spread between Treasury notes and lower quality corporate bonds accelerated last week, pushing out to their widest since the end of March. Whether this is a harbinger of declining risk appetite or rather more of a reflection of isolated weakness in a handful of sectors, including healthcare and telecommunications, remains to be seen. At least some investors decided not to wait to find out, as redemptions from high yield funds and ETFs rose.

The option-adjusted spread of the Bank of America Merrill Lynch High Yield index over ten-year Treasuries touched its lowest level in three years on October 24 at 3.38 percent. Since then, it has widened to 3.76 percent, with half of that move coming on Wednesday and Thursday last week. By comparison, the average spread over the past three years has been 5.09 percent, and the longer-term 20-year average has been 5.81 percent. Also of note, this spread widening is happening in the context of generally rising yields. The ten-year note climbed from 2.33 to 2.40 percent on the week, while the high yield index rose from 6.03 to 6.21 percent. Meanwhile, the yield curve between two and ten-year treasuries steepened sharply on Thursday and Friday to end the week at 74 basis points, after having fallen to its tightest spread since 2009 of 66 basis points at the start of trading on Thursday.

The Bond Market Bears Watching

Taken separately, the widening in credit spreads could indicate a diminishing appetite for risk among buyers of lower quality bonds. That might typically foreshadow an economic slowdown, as investors worry that the ability of highly leveraged companies to service their debt diminishes and the extra yield they are enjoying no longer sufficiently compensates for that risk.

On the other hand, rising yields and a steepening curve in the Treasury market might suggest the anticipation of accelerating economic activity and the possibility of rising inflationary pressure along with it. It could also be an expression of fear of rising supply, as the Federal Reserve slowly retreats as a major buyer, and the budget deficit comes under increasing pressure from tax reform. Then again, it could just be a bout of indigestion as markets adjust to the varying influences of supply and demand and the uncertainty of new leadership at the Fed. Whatever the message bond markets are sending, it bears watching, as bonds often serve as an early warning mechanism of what eventually manifests itself in stocks.

Monetary Policy Tightens While Investors Look Beyond Corporate Earnings

One thing is for certain, at least in the U.S., monetary policy is becoming less accommodative. The current effective fed funds rate is 1.16 percent. The Fed’s preferred inflation measure is the core Personal Consumption Expenditures (PCE) deflator, which for the twelve months through September is rising at a rate of 1.3 percent. This means that the overnight rate is still negative in real terms. But the Fed is widely expected to hike the overnight rate by another quarter point when it meets is December, pushing the effective rate to 1.41, or positive in real terms. This, of course, assumes that the core PCE itself experiences no rise in the interim, a prospect certainly open to debate against an unemployment rate of 4.1 percent. Just how restrictive an overnight rate that is positive in real terms by a slim 11 basis points is also debatable. But policy normalization is happening, albeit slowly. We won’t get October’s PCE report for several more weeks, but this week we will see how consumer prices behaved in October.

Last week’s weakness extended to stocks as well, as the S&P 500 suffered its first decline of the past nine weeks. To be sure, the loss was quite modest, just 0.2 percent, and after eight straight weeks of gains a pause of some kind should be expected. And whether the moves in junk bonds and stocks are related is unclear. The damage to stocks was done on Thursday, after the Senate version of the tax bill moving through Congress proposed a one-year delay in the effective date of the reduced corporate tax rate, raising concerns about 2018 corporate earnings estimates. Tax reform will undoubtedly remain the primary focus in the weeks ahead. Third quarter earnings season is mostly complete. More than 90 percent of companies have reported, and the results overall were, once again, better than expected. But that is rapidly becoming yesterday’s news. In a “what have you done for me lately” world of short-term results, the details and timing of tax reform have moved to center stage.

Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.
The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
The personal consumption expenditure (PCE) measure is the component statistic for consumption in gross domestic product (GDP) collected by the United States Bureau of Economic Analysis (BEA).
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
Data on the employment situation is released monthly be the Bureau of Labor Statistics. 
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