In like a lion
Against the backdrop of a decisive shift in U.S. Federal Reserve rhetoric and another record high for U.S. equities, high yield bond and senior secured loan prices continued to move higher this week. The gains capped another month of positive returns for each asset class, with high yield bonds and senior secured loans returning 1.56% and 0.59%, respectively, in February.1,2 For high yield bonds it was the 12th monthly gain of the past 13 months, and for senior secured loans it was the 13th straight positive monthly return.1,2 Year to date, high yield bonds have generated returns of approximately 3.1% amid ongoing investor optimism, consistent inflows into the asset class and solid corporate fundamentals.1 Notably, high yield bond yields are currently sitting at a 2.5-year low of approximately 5.58%.3 Year to date, senior secured loans are providing returns of 1.26% as bank loan mutual funds have recorded net inflows of approximately $7.8 billion.2,4 For further context, bank loan mutual funds have now posted 16 straight weekly inflows totaling $15.9 billion over that span as investors have increasingly sought out low duration assets to help protect against any potential rise in short-term interest rates.4
In a sharp shift in rhetoric, U.S. Fed officials appeared to lay the groundwork for a March rate hike. In remarks made early in the week, San Francisco Fed President Williams said that a rate hike at this month’s meeting is under “serious consideration” and New York Fed President Dudley said the case for raising rates “has become a lot more compelling.”5,6 Later, the Fed’s Lael Brainard, who is known to be dovish, also hinted that a rate hike is imminent, while comments delivered by U.S. Fed Chair Yellen on Friday appeared to affirm that a move is possible.7 A hike at the conclusion of the FOMC’s March 14–15 meeting would be a fairly quick turnabout from the FOMC’s February policy statement and Yellen’s recent testimony before Congress, neither of which appeared to be arguing for a rate hike.8,9 What changed? While the tone of the U.S. economic data hasn’t changed significantly, sentiment data has become more optimistic in recent weeks, and with the Dow Jones Industrial Average hitting another record, Fed officials might be taking comfort in the relative stability of financial markets.10,11
In a speech in Chicago on Friday afternoon, Yellen echoed comments made by other Fed officials suggesting that the U.S. economy “has essentially met the employment portion of our mandate and inflation is moving closer to our 2 percent objective.”12 The comments dovetail with data released this week showing a further drop in initial jobless claims and inflation rising in January at its fastest pace since 2012.13,14 U.S. Treasury yields rose across the curve this week after the personal consumption expenditures (PCE) index, the Fed’s preferred gauge of inflation, rose a seasonally adjusted 0.4% in January and climbed 1.9% from a year earlier.14,15 While core PCE remained relatively steady at 1.7% year over year, the report was widely viewed by investors as bolstering the case for a near-term rise in interest rates.14 Yellen’s comments are the last before the Fed enters a quiet period ahead of its two-day policy meeting, and if the nonfarm payrolls report on March 10 disappoints, expectations of a rate hike may cool.16,17 However, as of Friday, the market-implied probability of a hike at the Fed’s next meeting was 86%, up from just 40% the week before.18
Chart of the week: Inflation up, then down
- Market expectations that the FOMC will raise the federal funds target rate at its March meeting soared this week. The implied probability of a rate hike at the FOMC’s upcoming meeting climbed from approximately 40% just one week ago to as high as 86% late this week as both investor sentiment and global inflation data continued to firm.18 On Tuesday alone, three members of the FOMC spoke about the possibility that it may raise rates as soon as its mid-March meeting.19
- Amid the broad rally, yields on the 2-year and 10-year Treasury notes climbed approximately 17 basis points and 16 basis points, respectively, this week.20
- While investors have re-embraced the so-called reflation trade, a notable distinction is emerging. Markets appear to be preparing for higher inflation in the U.S. over the short term but have become increasingly sanguine about inflation over a longer period of time.
- As the chart highlights, the spread between 10-year and 2-year breakeven inflation rates has been declining since late November 2016 and, today, it is inverted.21 This means that markets see inflation picking up in the short term (2-year inflation expectations) but continue to expect a moderation in inflation over the long term (10 years).
1 Bank of America Merrill Lynch High Yield Master II Index.
2 Credit Suisse Leveraged Loan Index.
3 Bank of America Merrill Lynch High Yield Master II Index (yield-to-worst).
4 Thomson Reuters Lipper.
5 Federal Reserve Bank of San Francisco, http://bit.ly/2mjeaiH.
6 CNN, http://cnnmon.ie/2mmvBz5.
7 U.S. Federal Reserve, http://bit.ly/2lgM7B1.
8 U.S. Federal Reserve, http://bit.ly/2kWrohs.
9 U.S. Federal Reserve, http://bit.ly/2l4p216.
10 Bloomberg, http://bloom.bg/2mBaOsn.
11 Federal Reserve Bank of St. Louis, http://bit.ly/295DSwP.
12 U.S. Federal Reserve, http://bit.ly/2mjINV9.
13 U.S. Department of Labor, http://bit.ly/298eR69.
14 U.S. Department of Commerce, http://bit.ly/2mOhSP0.
15 Federal Reserve Bank of St. Louis, http://bit.ly/29ecBfp.
16 U.S. Federal Reserve, http://bit.ly/29y0IjN.
17 U.S. Department of Labor, http://bit.ly/2mUr8QM.
18 Bloomberg, based on CME data.
19 CNBC.com, http://cnb.cx/2lCsMFC.
20 U.S. Department of the Treasury, http://bit.ly/2lZqrrP.
21 Bloomberg, based on the spread between the 10-year and 2-year breakeven inflation rates.
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