June 11, 2019

It is often said that the bond market dictates to the Fed and not the other way around, making this past week’s commentary by Fed Chairman Jerome Powell as simply the Fed acknowledging that they will submit to the power of dramatically lower yields brought on by a massive rotation into U.S. Treasuries.

While the Fed did their own version of a “pivot” back in January, the bond market has put Mr. Powell & Co. under rising pressure to cut the Fed Funds Rate way sooner than the Fed had previously considered.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Once again, the Fed is playing catch-up with current economic conditions. Soft data from the labor market all but put a lock on the prospects of a quarter-point cut at the upcoming July 31 FOMC meeting. The fed funds futures market currently sees an 85.6% implied likelihood of a rate cut at the July 30-31 FOMC meeting (source: Briefing.com). In just these past two weeks, the economic calendar provided some clear hints of slower growth ahead, with several reports coming in below forecast.

Examples: The ISM Manufacturing Index for May was 52.1 versus 52.6 forecast. Construction Spending for April was 0.0% versus 0.4% forecast. Industrial Production for April was -0.5% versus 0.1% forecast. Durable Orders for April were -2.1% versus -2.0% forecast, and Friday’s employment data showed Non-farm Payrolls growing by 75K versus 180K forecast. That last one put a fork in the notion of an upcoming rate cut. Fed Fund Futures plunged on the labor report.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Jerome Powell to Wall Street – “I’ve Got Your Back”

As of Friday, the 2-year yield declined five basis points to 1.85%, and the 10-year dropped four basis points to 2.09%. While the 2/10 spread of 24 basis points has improved, there is an inversion in the 1, 3, and 6-month Treasuries – all yield more than the 10-year, which has pulled the Fed’s plan forward, per Mr. Powell’s latest public statement that the Fed would keep the expansion going, however possible.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Stocks vaulted higher on the tacit promise of a rate cut by the Fed chief, the S&P all but erasing market losses from the prior three weeks that saw the S&P violate its 200-day moving average for two sessions. The four-day 150-point S&P rally from Tuesday to Friday was juiced by Powell’s hint of rate cuts, reports of a delay in the Mexican tariffs, and crude oil getting bid higher following a protracted sell-off.

As it seems like “happy days are here again” for stocks, corporate spreads faced continued upward pressure due to persistent growth concerns and a sharp fall in the price of crude oil. Leading up to last week’s market reversal, the high yield spread widened by 39 basis points to 480 bps while the investment grade spread widened by six basis points to 117. The high yield spread was approaching its high from the start of the year while the investment grade spread remains a bit below its recent peak. On the positive side, the high yield spread remains under its 10-year average of around 525 bps.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The high yield market bears watching closely in the months ahead as the pricing of junk bonds has historically been a leading indicator for stocks. Credit analysts have growing concerns about growth prospects in China and Europe, but not all are worried as junk bond issuers sold over $82 billion of paper from January through April of this year, representing an increase of 28% over the prior-year period. So, for now anyway, it appears as if the junk bond and equity markets survived another recession scare.

Below is a long-term chart of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the most widely traded high-yield ETF. It is worth a glance, given the mixed messages the market has been sending us. Shares of HYG closed at $86.10 Friday and remain constructive. The low in December 2018 was $79.55 with the 52-week high being $87.04.

How this market trades going forward – under the assumption of a dovish Fed combating slower growth – will be very interesting. Each sell-off in HYG following the Great Recession has proven to be a buying opportunity in stocks, and the recent dip to $84.50 last Tuesday saw buyers step in with gusto. Until more data is known about whether the soft jobs report is a one-off or something more concerning, I expect the junk bond market to remain in a fairly tight range, especially with the Fed set to accommodate markets.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

What we do know is that stock markets operate on greed, while investment-grade bond markets operate on fear. Junk bond markets actually operate more on greed than fear, per the appetite for high yields. A better indicator of the health of the high-yield debt market is the direction of bid-offer spreads. While they are just one indicator of risk, junk bond managers closely follow these spreads as a measure of liquidity.

The bid-offer gap stood at 0.96 cents per dollar last Wednesday, near the highest level since the low point of December. Pimco’s fund managers, who oversee $1.75 trillion in bonds, state that such a spread “shows the cost to cash out of corporate bonds keeps getting bigger during sell offs, when funds often face redemptions.” Pimco also believes challenging liquidity conditions are here to stay as long as a trade war with China and political instability in Europe persist.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Here, too, is simply another way that investors can keep a pulse on a market that tends to have a high correlation with stocks. Like what we saw last week, both the junk bond market and the stock market can right themselves in a matter of just a few days. Rapidly rising and falling liquidity is the “new normal,” and we all just have to get used to it.

About The Author

Bryan Perry

Bryan Perry
SENIOR DIRECTOR

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry

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