A “patient” Fed has emboldened investors into risk on strategies thus far in 2019. The question now is whether the markets have read too much into recent Fed statements.
Thanks to the Fed, the bond markets have totally recovered from the fourth quarter selloffs. Year to date total returns are 8.9% for high yield and 5.6% for investment grade corporates. In each market the weakest credit grades have performed best. The Treasury market has underperformed, with a return of only 1.8%. The muni market has recorded a YTD return of 3.4%, led by a 4.1% return for the BBB credits. High yield munis have stopped outperforming, with a YTD return of 3.5%.
The yield on the corporate high yield index is now 6.15%, matching the June 2018 low and almost 200 bps less than in December. The spread to Treasuries is now 375 bps, down from 540 bps early this year, but still above the 2018 low of 320 bps. The typical range for that spread when defaults are low and the economic outlook is favorable is 350 to 450 bps. Spreads of A rated 10-year corporates to Treasuries are now around 75 bps, near the bottom of the 70-90 bps spreads that are typical in a strong market.
Munis are even more expensive than corporates. Ten-year AAA yields are now around 1.90%, down 100 bps since November, but still well above the 1.30% low seen in 2016. But, the muni-Treasury yield ratios have collapsed this year. Back in 2016, the 10-year AAA muni to 10-year Treasury yield ratio was 0.90. Today it is 0.75. Ratios are back to what we were used to seeing in the 1990s and earlier. That might not mean munis have no value here, but it will be very hard for them to outperform Treasuries in the months ahead.
Equities have appreciated the Fed just as, if not more than bonds. The S&P 500 Index is up 18.5% YTD!! And the flood of IPOs is reminiscent of 1999-2000.
The FOMC statement yesterday was again interpreted to promise no rate increases ever again, and a cut or two is possible this year. That apparently is not Chair Powell’s view. He, and one would think the majority of the Committee, are comfortable with the pace of economic growth. Even impressed by the latest GDP data. If inflation were not below 2%, there would be renewed speculation of rate hikes. Thus, I would not be adding to bond portfolios at these yields. We need to be as patient as the Fed.