Volatility returns as inflation expectations rise
Much of this week’s market activity was driven by last Friday’s strong jobs report, which showed average hourly earnings growing at 2.9%, the strongest rate since 2009.1 The jobs report set off a bout of volatility this week that included significant moves to the downside as well as the upside primarily within the equity market, but also the corporate credit and U.S. Treasury markets.2,3,4 Investors initially focused on potential inflationary pressures percolating within the U.S. economy. Yet market moves during the week ended February 8 seem to have been aggravated by an increased prevalence of passive and quantitative investors, suggesting that the extent of the market’s volatility may be disconnected from a still-healthy macroeconomic picture.5 For example, it was a light week of economic releases, yet January reports on consumer sentiment and U.S. manufacturing activity both came in higher than expected.6,7 Analysts’ estimates for first quarter 2018 corporate earnings also remain positive.8 Amid these upbeat data points, however, U.S. stocks briefly entered correction territory, and the CBOE Volatility Index (VIX), which measures market expectations of near-term volatility, reached its highest value since August 2015 before moderating slightly later in the week.2,9 Conditions were more mild within the corporate credit market, yet one measure of volatility still rose to its highest point since April 2017.10 The yield on the 10-year U.S. Treasury note oscillated during the week but ultimately reached a cyclical high of approximately 2.86%.11 Fears of a possible “overshoot” by the U.S. Federal Reserve likely triggered much of the week’s market activity. However, policymakers do not appear ready to adjust their pace and are still signaling that three hikes is their base case. In a speech this week, St. Louis Fed President James Bullard specifically cautioned investors against “interpreting good news from labor markets as translating directly into higher inflation.”12
High yield markets turn slightly lower
Corporate credit markets moved lower this week but stood as a relatively calm contrast to a volatile U.S. equity market that more than reversed its year-to-date gains. High yield bonds returned -1.10% for the week compared to -0.78% for investment grade bonds and -8.51% for stocks.2,3,13 Energy bonds were among the week’s largest decliners as oil prices fell in sympathy with the broader market as well as in response to the U.S. Department of Energy’s latest report that showed U.S. crude oil supply rose each of the past two weeks while domestic oil production continued to rise.14 High yield bonds have now experienced four consecutive weeks of outflows totaling approximately $8.7 billion as U.S. Treasuries continued their steady rise.15 Recent outflows place the asset class near its two largest-ever stretches of outflows, which occurred in June 2013 in the wake of the “taper tantrum” and in July 2014 when former Fed Chair Janet Yellen noted the FOMC could expedite its rate hike process.15,16,17 In a turnabout from recent performance, total returns on higher-rated high yield bonds this week generally outpaced that of lower-rated bonds. For example, BB rated bonds returned -1.07% for the week compared to -1.53% for CCC rated bonds.18,19 Year to date, however, lower-rated bonds continue to outperform.18,19
Senior secured loans off to a strong start in 2018
At -0.08%, returns on senior secured loans were slightly negative for the week and generally matched the broader retrenchment in market sentiment.20 Yet senior secured loans continue to draw investor interest as their floating rate coupon may act as a potential hedge against rising interest rates. For example, bank loan mutual funds experienced inflows of approximately $611 million for the week.15 It was by far the largest inflow of the past three weeks and came as the yield on the 10-year U.S. Treasury note itself reached a new cyclical high.11 Year to date, senior secured loans have returned approximately 1.04% compared to 0.57% for high yield bonds, -1.97% for investment grade bonds and -3.31% for stocks.2,3,13,20 While senior secured loans continue to be led by the lower end of the spectrum on a year-to-date basis, higher-rated loans outperformed this week. For the week, BB rated and B rated loans were relatively flat, generating returns of -0.05% and 0.01%, respectively.21,22 This compared to CCC rated loans, which returned -0.19% for the week.23
Chart of the week: Fed comments point to a slow rate-hike trajectory despite strong headline wage growth
- Last Friday’s jobs report brought to the forefront long-dormant fears that inflationary pressures may finally be emerging, as average hourly earnings for all private sector employees rose at their highest annual rate since June 2009.1
- Parsing the strong headline number, however, one can see that the wage increases were not evenly distributed across all workers. For example, wages for nonsupervisory employees, who account for approximately 82% of all employment in the U.S., remained flat in January at just 2.4% annual growth.24,25 Further, January’s nonsupervisory employees’ wages were relatively in line with the 2.3% average wage growth they saw in 2017.25
- As some investors fret about the Fed accelerating its activity, policymakers appear confident that they will remain on a slow trajectory in raising rates.
- John Williams, President of the Federal Reserve Bank of San Francisco, reiterated in a speech just last week that the FOMC won’t overreact in the months ahead. Williams noted that his message to those “concerned about a knee-jerk reaction from the Fed is that, as always, we’ll keep our focus on the dual mandate and let the data guide our decisions.”26
1 Bureau of Labor Statistics, average hourly earnings, http://bit.ly/2iYbHWM.
2 S&P 500 Index.
3 ICE BofAML U.S. High Yield Master II Index.
4 10-year U.S. Treasury note.
5 The Wall Street Journal, http://on.wsj.com/2BfQymx.
6 University of Michigan Surveys of Consumers, http://bit.ly/1gDEQwe. Consensus based on Bloomberg data.
7 U.S. Census Bureau, new orders for manufactured goods, http://bit.ly/2qvR2kK. Consensus based on Bloomberg data.
8 FactSet, http://bit.ly/2nLMeDJ.
9 Federal Reserve Bank of St. Louis, CBOE Volatility Index, http://bit.ly/295DSwP.
10 Bloomberg, as of February 9, 2018. Based on data from the Merrill Lynch Option Volatility Estimate (MOVE) Index.
11 Federal Reserve Bank of St. Louis, 10-year U.S. Treasury note, http://bit.ly/29ecBfp.
12 Federal Reserve Bank of St. Louis, page 15, http://bit.ly/2nXKuqD.
13 ICE BofAML U.S. Corporate Master Index.
14 U.S. Energy Information Administration, http://bit.ly/2ueQorn.
15 Thomson Reuters Lipper, based on data from J.P. Morgan High-Yield and Leveraged Loan Morning Intelligence, as of February 9, 2018.
16 Federal Reserve Bank of St. Louis, “Lessons from the Taper Tantrum,” http://bit.ly/2G0GUDr.
17 Nasdaq.com, http://bit.ly/2nMzjBz.
18 ICE BofAML U.S. High Yield BB Rated Index.
19 ICE BofAML U.S. High Yield CCC and Lower Rated Index.
20 Credit Suisse Leveraged Loan Index.
21 BB rated portion of the Credit Suisse Leveraged Loan Index.
22 B rated portion of the Credit Suisse Leveraged Loan Index.
23 CCC rated portion of the Credit Suisse Leveraged Loan Index.
24 Bureau of Labor Statistics.
25 Federal Reserve Bank of St. Louis, Average Hourly Earnings of Production and Nonsupervisory Employees: Total Private, http://bit.ly/2seYm4S.
26 Federal Reserve Bank of San Francisco, http://bit.ly/2Et0TgU.
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