Round Trip (Almost)

Like stocks, corporate bonds have recovered most of the ground lost during the fourth-quarter selloff.  Investment grade and high yield corporates have been, by far, the best performers thus far this year.  The high yield market has recorded a total return of 6.4% and the investment grade sector a return of 2.5% for the first two months of 2019.  Returns from the Treasury and muni markets are 0.19% and 1.3%, respectively.  The 30-year Treasury produced very strong returns last quarter, but had returns of -1.2% in February and -0.6% for the past two months.

The strong performance by high yield thus far this year is another reminder that unless we see signs of recession, selloffs such as that of the fourth quarter are buying opportunities.  The yields on the ICE high yield market index (formerly the Merrill Lynch Index) reached 8.10% in early January.  It is around 6.60% now.  The spread to Treasuries for that index reached almost 550 basis points.  At 390 bps now, that spread is back within the 350-450 bps range that is typical for periods of sustained GDP growth.  Thus, the high yield market now offers reasonable value.  The same might be said of investment grade corporates.

Municipal-Treasury yield ratios are OK, but not generous.  At near 0.80, the ratio of 10-year AAA muni yields to 10-year Treasury yields is near the traditional average.  The problem is that 10-year Treasury yields reflect expectations that the Fed will not be raising rates for the rest of this cycle.  That optimism has been sustained by Fedspeak these past several weeks.  There is, in my view, a significant risk that the Fed officials will need to revise those comments before too long.  The tone of the Beige Book tomorrow and the employment data on Friday could upset a Treasury market that is ill-prepared for any bad news.  Data released thus far in March, including the ISM indices and sales of new cars and trucks, do not point to a sustained slowdown in GDP growth.

Fed officials are simply talking too much.  There was a time when they would never comment on the outlook for monetary policy.  Now, they can’t stop talking about the outlook for the fed funds rate.  If, as seems likely, the first-quarter slowdown in GDP growth is due to transitory factors, and growth returns to the 2%-3% range, those same Fed officials will need to “communicate” to the markets that prospects for more rate increases have increased.  They will then be criticized for misleading the markets once again.  And, they will have only themselves to blame for that criticism.



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