Credit spreads backed up 6 basis points last week, with the greatest widening occurring Thursday as the Morningstar Corporate Bond Index ended the week at +150.
Investors quickly became sellers as headline risk surrounding the US fiscal cliff negotiations pressured markets, which were simultaneously tasked with digesting another large slew of new issues. In fact, we heard from one bond trader that the amount of new issue volume over the past few weeks may have finally soaked up the cash sitting on the sidelines in many investor portfolios. This trader further reported that many clients were selling front-end paper to make room for new issues. While a rising tide has lifted all boats and credit spreads have tightened across the board over the past few months, we generally expect the rate of improvement in credit quality will stagnate as global economies weaken and corporate earnings are pressured. We believe this dynamic--tight spreads and stagnant credit quality--will limit further credit spread tightening and lead to greater differentiation among issuer credit quality over the near term.
Even though the credit market weakened last week, the new issue market provided plenty of volume for investors to choose from. We counted $30 billion worth of deals priced last week among the issuers we cover.
The new issue markets will be quiet this week as the US takes time off for Thanksgiving, leaving only a two-week window for issuers who want to issue debt before the holiday season and year-end hit.
Eurozone Officially Enters a Recession
According to Eurostat, GDP fell 0.1% in the euro area during the third quarter. This decline comes on the heels of a 0.2% decline in the second quarter, fitting the standard definition of a recession.
Among the core countries, German GDP rose 0.3% and French GDP rose 0.2%. However, the strength in these nations was not enough to offset declines of 0.2% in Italy, 0.3% in Spain, and 0.8% in Portugal. Business indicators such as industrial production, which declined 2.5% in September, and the purchasing managers index, which fell to 45.7 in October from 46.1 in September (a level below 50 indicates contraction), are continuing to weaken, likely foretelling even greater contraction yet to come. The European Commission lowered its forecast for 2013 GDP growth in the eurozone to 0.1% from 1.0%, a disappointingly low growth rate considering consensus estimates for 2012 are for a 0.4% decline.
As the economies continue to contract, sovereign debt measures are weakening to the point that many countries' credit ratings may be lowered. For example, Moody's is reportedly reassessing its Aaa rating for the UK as the country's efforts to reduce debt metrics are being hindered by a weak economy. The agency will review its rating at the beginning of next year. As the economies soften, inflation has continued to decline, dropping to 2.5% in October, and the core rate dropped to 1.5%. As inflation subsides this may allow the European Central Bank room to consider actions to improve economic conditions.
Federal Reserve Hints at Changing Policy Guidance
In a speech given last week by Janet Yellen, vice chair of the board of governors of the Federal Reserve, regarding the evolution of central bank communications, she explained the rationale behind potentially changing the content of the Federal Reserve's communication to the public. She posited that the Federal Open Market Committee may begin to include guidance on economic conditions that would need to prevail before increasing the federal funds rate may be appropriate. She further stated that the FOMC could eliminate the calendar date guidance completely.
She highlighted an example from Charles Evans, president of the Chicago Fed, that the FOMC would commit to holding the federal funds rate at its current level at least until unemployment has declined below 7%, provided that inflation over the medium term remains below 3%. She further highlighted the suggestion of Narayana Kocherlakota, president of the Minneapolis Fed, that the thresholds be as low as 5.5% for unemployment and 2.25% for the medium-term inflation outlook. We also saw additional language in the FOMC's October minutes, released last week, that suggests the FOMC is considering changing its communications to incorporate these metrics in its guidance. We would not be surprised to see these changes made sometime over the next few FOMC meetings.
