Weekly Fixed Income Commentary: Dovish central banks push Treasury yields lower
Highlights
- Investment grade corporate bonds recorded their best week since late January.
- Municipal bonds performed well last week, as yields moved generally lower.
- High yield corporates posted a moderate loss for only the second time in the past 11 weeks.
U.S. Treasury rates fell last week across the yield curve, led by 5- and 10-year maturities. The European Central Bank (ECB) surprised markets with a new round of stimulative bank financing, and U.S. Federal Reserve (Fed) officials indicated the Fed will likely hold firm on rates at the March meeting. These dovish actions helped spark a risk-off mode for financial markets, benefiting Treasuries and other government bonds.
Treasury yields decline with European rates
U.S. Treasury yields fell last week across the yield curve, led by 5- and 10-year maturities.1 The biggest decline occurred on Thursday when the European Central Bank (ECB) surprised the market with its dovish actions. The ECB slashed its 2019 growth forecast, pushed off its forecast for a policy rate hike and announced a new series of low-cost loans to its banking sector. The unexpected announcement of a new round of bank financing pushed European rates lower, and Treasuries followed. The February payroll report came in much weaker than expected, adding only 20,000 jobs. Market reaction was muted, with weakness in job growth offset by rising wages.
All U.S. sectors delivered positive total returns, except the high yield, preferred and senior loan sectors.1 All sectors underperformed similar-duration Treasuries as spreads widened.1 The credit sectors posted the weakest relative returns, led by the high yield sector.1 The underperformance of the high yield sector was broad-based, but led by the lower quality buckets.1 The global aggregate sector posted a positive total return and only marginally underperformed Treasuries.1 The European sector posted the strongest relative performance.1
Several Fed officials indicate that the committee likely intends to keep the fed funds rate unchanged at the March meeting and perhaps longer. Fed officials cited muted inflation and heightened downside risks from slowing global growth and policy uncertainty as reasons to take a wait-and-see approach. The market has currently priced in virtually a zero percent chance of a rate hike in 2019. The Fed will provide a new round of forecasts, including the forecast for the path of the fed funds rate.
The market has currently priced in virtually a zero percent chance of a Fed rate hike in 2019.
Municipal demand continues to outpace supply
Municipal bonds performed well last week, as yields moved generally lower.1 The new issue calendar was light at $5 billion and deals were well subscribed.2 Fund flow totaled nearly $800 million.3 New issuance is expected to be undersized again at just $4 billion.2
Municipal yields declined 7 to 11 basis points across the intermediate and longer range of the yield curve last week.1 Demand continues to outpace the level of supply from the primary market. As the April 15 tax deadline draws closer, high-income earners are getting a clearer picture of their individual tax bills, which should continue to support the tax-advantaged nature of the municipal market.
The state of California issued $2.3 billion general obligation bonds (rated Aa3/AA-).4 Much of the deal was structured in longer maturities that were well received. Secondary market trading has been strong with some bonds trading as much as 10 basis points lower in yield.
High yield municipal bond fund flows continued at a very strong pace last week at $374 million, and performance has been strong year to date.1,3 We can see a clearer performance picture when breaking it down into rates, ratios and spreads. General long-term interest rates (30-year U.S. Treasury) have been generally flat, municipal-to-Treasury yield ratios have contracted from 100% to 96% (worth 13 bps of outperformance) and credit spreads have tightened by 8 bps on average.1 Combining the three components leaves a net yield decrease of -21 bps (0-13-8=-21). We believe credit spreads could have tightened further with more supply. However, with fund flows continuing to build and seasonal supply expected to pick up soon, we expect accelerated spread tightening in the coming months.
Investment grade corporates shine in a risk-off week
Investment grade corporate bonds recorded their best week since late January, outperforming all taxable sectors except Treasuries.1 A shaky equity market and heavy supply took a modest toll on investment grade spreads, however, which widened slightly during the week.1 Credit-specific headlines triggered more severe idiosyncratic widening among some large issuers. Overall, the asset class continues to benefit from strong demand and the Fed’s dovish tilt.
High yield corporates posted a moderate loss for only the second time in the past 11 weeks.1 Global growth fears and February’s surprisingly downbeat jobs report dimmed investor sentiment. Fund flows were -$2 billion, after a combined $10 billion of inflows in January and February.3 Given the week’s risk-off tone, CCC-rated issues fared substantially worse than higher quality (BB and B) bonds.1
CCC-rated issues fared substantially worse than higher quality bonds.
Emerging market (EM) debt returns inched lower despite a ninth straight week of inflows.1 Sovereign spreads widened, mostly due to high-yield bonds.1 Trading was orderly, with no signs of panicked selling. Lower-beta (less volatile) countries outperformed. Corporate EM spreads also gapped wider amid risks associated with Turkey. Local rates were resilient in the face of currency weakening following the ECB’s dovish March 7 meeting. Last week’s laggards included the South African rand, Russian ruble and Mexican peso.
In focus: ECB out-doves the Fed with new stimulus
The European Central Bank (ECB) surprised markets last week by taking an even more dovish stance than expected. While a continuation of accommodative monetary policy was a foregone conclusion, ECB President Mario Draghi took it a step further.
Draghi announced not only a delay in rate hikes until at least 2020, but also fresh stimulus in the form of very low-interest-rate loans to eurozone banks. He also shared newly downgraded growth forecasts. These moves come only three months after the ECB ended its long-running bond-buying program and confirmed it was still eyeing a resumption of rate hikes in mid-2019.
If a dovish policy U-turn by a major central bank that anticipates economic slowing (but not a recession) sounds familiar, it is. The ECB’s action, though more drastic, was thematically similar to the Fed’s January 30 statement eliminating any mention of further U.S. rate increases.
Financial markets have already priced in zero chance of a hike at the Fed’s March 20 meeting and will have to wait until then to learn if Chair Jerome Powell and his colleagues, like their ECB counterparts, have materially revised their economic or policy outlook. We’re not convinced they have, but we expect the Fed to provide clarifying details on plans to shrink its balance sheet. Whether market reaction will be positive or negative will depend on the details.
1 Bloomberg L.P.
2 The Bond Buyer, 8 Mar 2019.
3 Lipper Fund Flows.
4 Market Insight, MMA Research, 6 Mar 2019.