Oil prices have dropped by approximately $5 per barrel - almost 10% - since the beginning of March, with most of the price drop occurring last week. After suffering deep losses in the latter half of 2015 and early 2016, when oil prices dropped to as low as $30 per barrel, investors in corporate bonds have since kept a close eye on the price of oil.
As the price of oil has sunk, corporate credit spreads in the energy sector have begun to widen out, pulling the overall index wider as well. Last week, the Morningstar Corporate Bond Index, our proxy for the investment-grade bond market, widened 5 basis points to +123, and the Bank of America Merrill Lynch High Yield Master Index widened 29 basis points to +389. The energy sector of the Morningstar Corporate Bond Index widened 8 basis points, and the energy sector of the high-yield index widened 43 basis points.
Investors have also been closely monitoring economic activity. Recent economic data has led the Atlanta Federal Reserve to lower its GDPNow estimate for economic growth in the first quarter of 2017 to a 1.2% rate. This estimate had been as high as 2.5% as recently as Feb. 27. Factors leading to the lower estimate include construction spending, light-vehicle sales, and manufacturing reports.
Rate Hike a Foregone Conclusion?
According to CME data, the market-implied probability priced into the federal funds futures market for a rate hike this week is 93%. Two weeks ago, the market-implied probability was only 22%. Between comments by Federal Reserve Chair Janet Yellen in a recent speech in Chicago and intimations from other Federal Reserve officers over the past two weeks, the market has priced in a rate hike at the conclusion of the March 14 meeting as a foregone conclusion.
However, even if the Fed increases the federal funds rate by 25 basis points, to 75-100 basis points, this range still represents a highly simulative monetary policy. Before the 2008-09 credit crisis, the lowest the federal funds rate had even been targeted was 1% in 2003, when the Fed was trying to prop up the economy after the tech bubble burst.
U.S. Treasury bond prices continued to sink lower last week as investors price in an expectation for higher interest rates. The yield on the 2-year Treasury bond rose 5 basis points to 1.36%, the highest it has been since 2009. The 5-year bond rose 9 basis points to 2.10%, the 10-year increased 9 basis points to 2.57%, and the 30-year rose 9 basis points to 3.16%.
Not only is the fed futures market pricing in a March rate hike to 75-100 basis points, but also the probability of two more rate hikes has risen precipitously over the past few weeks. The probability that the fed funds rate will be over 1.00% following the June meeting rose above 55%, and the probability of a further rate hike taking the fed funds rate over 1.25% after the December meeting rose to almost 60%.
While Fed looks to tighten monetary policy, the European Central Bank is holding steady on its loose monetary policy. The ECB has kept short-term interest rates at negative yields and is maintaining its EUR 60 billion monthly purchase program through year-end. However, ECB President Mario Draghi recently alluded to signs of strengthening in the eurozone and the re-emergence of inflation. Many investors took this to mean that the ECB is edging closer to the time that it will dial back its dovish monetary policy.
The yield on the German 10-year sovereign bonds rose 13 basis points last week to 0.49%, its highest yield in over a year. Interest rates on both Italian and Spanish sovereign bonds widened 27 and 21 basis points, respectively, as the spread between those countries’ bonds and German bonds widened out.
Lower Oil Prices Lead to Withdrawals
With oil prices sinking below $50 per barrel, investors in the high-yield market looked to reduce risk and redeemed $2.2 billion of assets out of high-yield exchange-traded funds and open-end funds. As oil prices sank, corporate credit spreads in the oil sector began to widen out as investors remain skittish of the energy sector, having suffered significant losses when oil prices dropped precipitously in the second half of 2015 and early 2016.
The preponderance of withdrawals were felt in the ETF asset class, which is generally considered to be a category for institutional investors, known to trade in and out of asset classes more quickly than individual investors.
