During the first quarter, the US economy expanded at a much higher rate than anyone originally expected. GDP rose at a 3.2% annual rate in the first quarter compared with the consensus expectation of 2.3%. This was the strongest reading for the first quarter in the past four years and was a significant acceleration from the fourth quarter of 2018, when GDP increased at a 2.2% annual rate.
Economic activity was bolstered by increases in net exports, inventory, and government spending. Not only was economic activity in the first quarter stronger than expected, but momentum accelerated toward the end of the quarter. For example, durable goods orders rose 2.7% in March compared with February, retail sales increased 1.6% in March, and unemployment has remained exceptionally low.
The S&P 500 increased 1.20% last week and closed at a new high on Friday. Year to date, the index has risen 17.27%. While the equity markets in the United States are hitting record highs, the rally in the corporate bond market has taken a break, as credit spreads in both the investment-grade and high-yield markets have traded in a very narrow band over the past two weeks. For example, the average credit spread of the Morningstar Corporate Bond Index – our proxy for the investment-grade corporate bond market – closed at +113 last Friday, the same level as April 12.
In the high-yield market, junk bonds have experienced a little bit of weakness as the average spread of the ICE Bank of America Merrill Lynch High Yield Master II Index has widened 8 basis points over the past two weeks to +376. However, while credit spreads have not experienced much volatility recently, both investment-grade and high-yield bonds have performed extremely well thus far this year. Year to date, the average spread in the investment-grade market has tightened 44 basis points and in the high-yield market has tightened 157 basis points. The tightening of credit spreads and decrease in underlying interest rates have driven the investment-grade index 5.67% higher and the high-yield index 8.75%.
Short End of Yield Curve Weakens
Although the rally in the corporate bond market took a breather, the rally in the Treasury bond market has continued. At the end of the week, the yields on 2-, 5-, 10-, and 30-year bonds were 2.28%, 2.29%, 2.50%, and 2.92%, respectively. The short end of the yield curve has performed the best year to date as the yields on 2-year and 5-year bonds have declined 21 and 22 basis points. The 10-year yield has dropped 18 basis points and the 30-year has lagged behind, decreasing 9 basis points.
The market is pricing in with near certainty that the Federal Reserve will not make any change to the federal-funds rate following its meeting this week. However, according to the CME FedWatch Tool, the market-implied probability that the federal-funds rate will be cut by 25 basis points or more by the end of this year is 64%. Although economic activity has been stronger than most expected, inflation measures have remained muted. For example, the core reading of the personal consumption expenditure index rose only 1.3% in the first quarter. In addition, while the headline readings for recently released economic metrics have been strong, many of the factors that bolstered growth in the first quarter may not continue over the next few quarters.
The strength in sovereign bonds has been widespread thus far this year as prices have surged across the developed markets. One data point of note is that the yield on the 10-year German bund has dropped back into negative territory. While the yield was negative in late March for a few days, it has not resided at a negative reading for a meaningful amount of time since September 2016. A weak European economic outlook and the ongoing Brexit drama have prompted speculation that the European Central Bank may need to re-engage its monetary stimulus programmes and that any increases in short-term interest rates are still way in the future.
