Prospect for Trade Truce With China Drives Credit Spreads Tighter

Sentiment in the marketplace last week was completely driven by the on-again, off-again, and finally back on-again trade negotiations with China, ending the week on a positive note. Concluding the negotiations on Thursday and Friday, the two countries reached an agreement on the first phase of a trade deal. The agreement reportedly will delay the implementation of tariffs that were scheduled to begin this week and covers several different subjects that have been heavily contested, including intellectual property, access to the Chinese financial markets, and purchases of agricultural products. The markets were further bolstered by the announcement from the Federal Reserve that starting on Tuesday, it would begin purchasing Treasury bills in the open market at a pace of $60 billion per month. The purchases are expected to provide enough extra reserves and liquidity into the banking system to alleviate the strains experienced in the repurchase market over the past few weeks.

On Thursday and Friday, risk assets surged, sending the equity market up, credit spreads tighter, and economically sensitive commodities such as oil and copper higher. In the corporate bond market, on a week-over-week basis, the Morningstar Corporate Bond Index tightened 4 basis points to +120 and in the high-yield market, the ICE BofAML High-Yield Master II Index gapped 28 basis points tighter to +410.

Source: Morningstar, Inc., ICE BofAML Global Indexes. Data as of 10/11/19.

As investors became less concerned about the contagion from global economic weakness reaching U.S. shores, Treasury bonds sold off sending yields higher across the yield curve. After declining significantly the prior week, this week's jump in yields almost completely offset the prior week's decline. In the short end of the curve, the interest rate on the 2-year bond rose 19 basis points to 1.59% and toward the middle of the curve, the yield on both the 5-year and the 10-year increased 21 basis points to 1.55% and 1.73%, respectively. In the longest end of the curve, the 30-year bond rose by 19 basis points to 2.20%.

The market also reversed course and after pricing in higher probabilities earlier this month of additional near-term rate cuts, the market began to price in a lower probability the Federal Reserve will cut the federal funds rate in October and again in December. According to the CME FedWatch Tool, the probability that the Fed will cut the federal funds rate by 25 basis points to a range of 1.50% to 1.75% in October declined slightly to 72% from 78% last week. The bigger change was the declining probability the Fed would cut rates even further in December to a range of 1.25% to 1.50%, which fell to 26% from 42%.

For the week ended Wednesday, Oct. 9, both high-yield open-end and exchange-traded funds experienced significant withdrawals. In total, there were $1.6 billion of net outflows from the high-yield asset class, consisting of $0.4 billion of withdrawals across the open-end mutual funds and $1.2 billion of net redemptions among the high-yield exchange-traded funds (ETFs). Year-to-date inflows into the high-yield asset class remain a solid $18.4 billion, consisting of $13.2 billion worth of net unit creation among the high-yield ETFs and $5.2 billion of inflows across the high-yield open-end mutual funds.

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