Modest declines
Corporate credit prices saw modest gains in the shortened holiday week, underpinned by a decline in Treasury yields, a rise in oil prices and ongoing investor demand for income.1,2 High yield bonds returned approximately 0.24% during the week ended September 8 after registering a modest loss for the month of August.3 Last month’s -0.03% decline marked the first negative return for the asset class since March, when high yield bonds returned -0.21%.3 For context, high yield bonds remain one of the better-performing fixed income asset classes in 2017, having returned approximately 6.34% through the first eight months of the year.3 Underperforming in August were CCC rated bonds (-0.80%) versus both B rated bonds (-0.09%) and BB rated bonds (0.25%) after outperforming their higher-rated counterparts throughout most of the year.4,5,6 Despite this recent shift in sentiment, CCC rated bonds remain an outperformer in 2017, providing year-to-date returns of nearly 8.30%.4 Senior secured loans generated a mildly positive return this week even as interest rate concerns continued to dissipate and bank loan mutual funds registered a small weekly outflow.7,8 Like high yield bonds, senior secured loans saw a modest decline in August (-0.14%), with CCC rated loans (-0.77%) underperforming both B rated loans (-0.13%) and BB rated loans (-0.13%) last month.7,9,10,11 Year to date, senior secured loans are now providing returns of approximately 2.72%, with the retail industry the only negative performer for the asset class so far in 2017.7,12

Dovish exit
Remarks from a handful of U.S. Federal Reserve officials drew attention this week for their perceived dovishness, raising fresh doubts about a December interest rate hike. In a speech at the Economic Club of New York, Fed Governor Lael Brainard suggested the Fed should be cautious about raising short-term interest rates in light of persistently low levels of inflation.13 While indicating support for beginning to shrink the central bank’s $4.5 trillion balance sheet, Brainard said it may be prudent to raise the federal funds rate more gradually given inflation had not hit the Fed’s 2% annual inflation target over the past five years.14 Meanwhile, Dallas Federal Reserve Bank President Robert Kaplan said he believes “we can afford to be patient” and Minneapolis Fed President Neel Kashkari went so far as to suggest that recent Fed rate hikes may be “doing real harm to the economy.”15 While Fed Reserve Vice Chair Stanley Fischer’s resignation did not come as a complete surprise, his earlier-than-expected exit caused some further uncertainty around monetary policy going forward.16 Viewed as one of the more hawkish members of the policy setting committee, Fischer’s departure reduces the number of members that have argued for policy normalization sooner rather than later.16 Taken together, the news coming from the Fed this week was generally viewed as dovish and the bond market reacted accordingly.1

Lowered expectations
Rising North Korea tensions, concerns around Hurricane Irma and a run of soft inflation data weighed on Treasury yields this week, sending the yield on the U.S. 10-year Treasury note to its lowest level since last November.1 Last week’s reading of the personal consumption expenditures (PCE) price index provided fresh evidence of cooling inflation, with the Fed’s preferred gauge of inflation coming in at 1.4%, well below the central bank’s 2% target.17 Meanwhile, wage growth has yet to materialize, with August’s nonfarm payrolls report showing average hourly earnings rising a mere 0.1%.18 While low inflation remains top of mind for investors, this week’s decline in Treasury yields were further framed by a decline in the U.S. dollar and an extension of the U.S. debt ceiling by three months, coinciding with the FOMC’s policy meeting on December 12–13.19,20,21 Despite the imminent unwinding of the Fed’s balance sheet, this week saw further evidence of interest rate complacency as Fed fund futures indicated traders’ declining expectations of another rate hike in 2017.22 By week’s end, odds of a December rate hike had slipped to less than 30%, down from nearly 50% a month ago.22

Chart of the week: Inflation expectations downtrend

  • Inflation data released last week showed that pricing pressures remained constrained in July. The year-over-year change in the personal consumption expenditures index, the Fed’s preferred measure of inflation, was just 1.4% in July, and has either moved sideways or fallen each month since February.23
  • In light of another month of weak inflation data, three voting members of the FOMC – Robert Kaplan, Neel Kashkari and Lael Brainard – this week expressed their doubts about the need to raise interest rates again in 2017.15 Brainard’s comments in a speech at the Economic Club of New York on Tuesday drew the most attention from investors and helped push down the implied probability of a rate hike at the Fed’s December meeting by more than 9%.24
  • In her speech, Brainard noted that, while the U.S. economy is currently on “solid footing,” there remains a “notable disconnect” between today’s tight labor market and inflation readings, which have remained “stubbornly below target for five years.”13
  • Brainard highlighted a range of inflation models that suggest underlying inflation trends have moved lower over the last decade, and urged policymakers to be cautious about raising interest rates until inflation moves closer to the Fed’s target of 2%.13
  • Indeed, five-year inflation expectations have declined markedly in the last three years and, as the chart highlights, are currently under their average since 2004.25 Notably, inflation expectations today are nearly 0.5% below their average between 2004 and 2007, the last time when unemployment was approximately as low as it is today.26
  • We believe current, and longer-term, inflation trends seem to indicate that interest rates are likely to remain low for some time.

1 Federal Reserve Bank of St. Louis, http://bit.ly/29ecBfp.
2 Federal Reserve Bank of St. Louis, http://bit.ly/292Tgue.
3 Bank of America Merrill Lynch U.S. High Yield Master II Index.
4 Bank of America Merrill Lynch U.S. High Yield CCC and Lower Rated Index.
5 Bank of America Merrill Lynch U.S. High Yield B Rated Index.
6 Bank of America Merrill Lynch U.S. High Yield BB Rated Index.
7 Credit Suisse Leveraged Loan Index.
8 Thomson Reuters Lipper.
9 Credit Suisse Leveraged Loan Index (CCC rated component).
10 Credit Suisse Leveraged Loan Index (B rated component).
11 Credit Suisse Leveraged Loan Index (BB rated component).
12 Credit Suisse Leveraged Loan Index (retail component).
13 U.S. Federal Reserve, http://bit.ly/2wbXRFv.
14 Reuters, http://reut.rs/2vKOsp3.
15 Reuters, http://reut.rs/2wL5K8E.
16 Dow Jones Newswires, http://fxn.ws/2wclWMp.
17 Bureau of Economic Analysis, http://bit.ly/2mOhSP0.
18 Bureau of Labor Statistics, http://bit.ly/2iYbHWM.
19 MarketWatch, http://on.mktw.net/2gOKJAD.
20 CNN, http://cnn.it/2vT30Hs.
21 U.S. Federal Reserve, http://bit.ly/2wOb37h.
22 Bloomberg, based on CME data.
23 Bureau of Economic Analysis, http://bit.ly/2f7pee9.
24 Bloomberg, based on CME data.
25 University of Michigan Surveys of Consumers, Expected Changes in Prices During the Next Five Years, http://bit.ly/2hOoe1J.
26 Bureau of Labor Statistics, http://bit.ly/2ibnFLh.


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