Slow and steady
In what was a relatively quiet week leading up to U.S. Federal Chair Yellen’s speech in Jackson Hole, Wyoming, the corporate credit markets moved steadily higher. High yield bonds and senior secured loans both generated modest gains in a week that saw equities remain flat and oil prices post mild declines. For high yield bonds, a 0.32% return during the week ended August 25 brings the month-to-date return to approximately 2.07% and puts the asset class on track for its seventh consecutive positive monthly return.1 Over that time period, high yield bonds have experienced significant yield compression, with yields tightening to approximately 6.34% from a high of 10.1% earlier this year and currently sitting at 13-month lows.1 The rally since early 2016 has taken place against the backdrop of significant inflows into the asset class. Year to date, high yield bond mutual funds have attracted a net $9.8 billion, compared to net outflows of $16.4 billion and $23.9 billion in 2015 and 2014, respectively.2 Despite a week-over-week decline in oil prices, high yield energy bonds continued to trend higher. Month to date, high yield energy bonds are providing returns of approximately 3.9% as oil prices have risen more than 16%.3,4 For senior secured loans, rising LIBOR (London Interbank Offered Rate) and relative value considerations have helped to draw increased inflows into the asset class in recent weeks.5 Bank loan mutual funds have seen net inflows of nearly $1.1 billion since the beginning of July, reversing a portion of the outflows experienced earlier in 2016 and helping the asset class to a year-to-date return of approximately 6.4%.2
Time to move?
While this week’s Economic Policy Symposium in Jackson Hole was not expected to focus on the short-term outlook for interest rates, U.S. Fed Chair Yellen’s comments echoed those of other Fed officials who have recently argued for a near-term rate hike.6 Despite growing consensus that the neutral rate (or, the interest rate that will keep the economy growing and inflation stable) has likely fallen due to slower economic growth, Fed officials have grown increasingly vocal over the past few weeks in their calls for a rise in short-term interest rates. The day before Yellen took center stage, Kansas City Fed President Esther George reiterated her belief that it is time to raise rates. “When I look at where we are with the job market and when I look at inflation and our forecast, I think it’s time to move,” George said in an interview Thursday.7 “Even if you believe that (the neutral rate) is lower, it might warrant that we should begin moving more systematically than we have been.”7 In July, George was the only official to dissent against the decision to leave rates unchanged, but her viewpoint appears to have become less of an outlier in recent weeks. Federal Reserve Bank of San Francisco President Williams, New York Fed President Dudley and Fed Vice Chairman Fischer have all recently said that the case for raising interest rates has grown stronger.8,9
The long run
Although Yellen gave no guidance on when an interest rate hike may come, she said the U.S. economy is nearing the Fed’s goals of “maximum employment and price stability,” which has strengthened the “case for an increase in the federal funds rate.”6 In response, U.S. Treasuries flattened across the curve, with the spread differential between two-year notes and 30-year bonds declining to the tightest level since January 2008 and 10-year U.S. government bonds continuing to trade in the narrowest range in a decade.10 Despite the increased hawkishness, market expectations of a rate hike before year-end, at approximately 57%, remains markedly different than the Fed’s rhetoric would suggest.11 One risk is that the market could be caught flat-footed should the Fed begin to move more aggressively to tighten policy over the near-term. However, those that are focused on the longer term may be more interested in where the Fed’s expectation of the longer-run neutral rate appears to be heading.
Chart of the week: Long-term lows
- Near the end of a summer during which investors have had to digest a series of mixed, and sometimes conflicting, messages from members of the Federal Reserve, Fed Chair Yellen asserted in a speech at the Fed’s annual meeting in Jackson Hole on Friday that the “case for an increase in the federal funds rate has strengthened in recent months.”6
- Despite short-term questions surrounding when the FOMC may raise the federal funds rate, there appears to be growing consensus that global equilibrium rates, or long-term neutral rate, has declined significantly in recent years.
- According to a June 2016 working paper published by the Federal Reserve Bank of San Francisco, estimated neutral interest rates for Canada and the United States “are [currently] close to all-time lows,” while those for the Euro area and the United Kingdom “rebounded in 2010, but then fell sharply again following the Euro crisis.” 12
- Federal Reserve Bank of San Francisco President Williams affirmed this sentiment in an August 15 paper in which he cited shifting demographics and slower productivity and economic growth as reasons why long-term interest rates are likely “to stay lower than we’ve come to expect in the past.” 13
1 Bank of America Merrill Lynch High Yield Master II Index.
2 Thomson Reuters Lipper.
3 Bank of America Merrill Lynch High Yield Energy Index.
4 Federal Reserve Bank of St. Louis, https://goo.gl/hbup9D.
5 Federal Reserve Bank of St. Louis, http://goo.gl/Vh8CaO.
6 U.S. Federal Reserve, http://goo.gl/nWxtKi.
7 Bloomberg, http://goo.gl/JeNFmk.
8 Federal Reserve Bank of San Francisco, http://goo.gl/5Y4KOZ.
9 Barrons, http://goo.gl/qgYJjU.
10 MarketWatch, http://goo.gl/EJO5kv.
11 Bloomberg based on CME data.
12 Federal Reserve Bank of San Francisco Working Paper 2016-11, http://bit.ly/2bDVdBO.
13 Federal Reserve Bank of San Francisco, http://bit.ly/2bbYuFD.
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