Bonds Indicate Market Weakness Ahead of Stocks
The remarkable surge in U.S. high-yield or “junk” bonds, which began in late October, temporarily halted on Friday. This occurrence followed the release of a strong jobs report for November, raising concerns about the market’s anticipation of significant rate cuts in 2024.
Individual and Institutional Investors Affected
Both of the junk-bond sector’s largest exchange-traded funds (ETFs) experienced declines on Friday, implying imminent weekly losses. These funds are popular among individual investors and serve as a means for institutional investors to manage liquidity during turbulent market conditions.
According to FactSet data, both the $18 billion Shares iBoxx $ High Yield Corporate Bond ETF (HYG) and the nearly $8 billion SPDR Bloomberg High Yield Bond ETF (JNK) showed around a 0.2% decrease on Friday afternoon. These levels align closely with their respective weekly losses.
Junk-Bonds: A Canary in the Coal Mine
The junk-bond market has a reputation for signaling potential shifts in sentiment within financial markets. In light of recent events, investors should exercise caution.
John McClain, portfolio manager at Brandywine Global Investment Management, expressed his concerns during a phone call, stating, “I think we have gotten far too over our skis. You saw a rapid move in the 10-year yield from 4% to 5%, and from 5% back to about 4.1%.”
Treasury Yields Experience Fluctuations
On Friday, the 10-year Treasury yield (BX:TMUBMUSD10Y) rose by approximately nine basis points to reach approximately 4.24%. In normal market conditions, this rate typically undergoes minor daily fluctuations in either direction.
It is important to closely monitor these developments in the junk-bond market as they have the potential to impact broader financial markets.
The Retreat in Benchmark Borrowing Costs Indicates Optimism for Rate Cuts
The month of November has seen a retreat in benchmark borrowing costs, signaling growing optimism about easing U.S. inflation that may lead the Federal Reserve to consider significant rate cuts in the coming year.
Shifting Expectations for Fed Rate Cut
Traders have experienced a change in expectations as they now believe that the first rate cut by the Federal Reserve will occur in May instead of March, according to the CME FedWatch tool.
Maintaining Skepticism Amid Optimism
Despite the positive outlook, there are those who remain doubtful about the final stage of controlling inflation. They anticipate a challenging path to achieve the Federal Reserve’s target of 2%.
Favorable Conditions for Risk Assets
The recent optimism surrounding rate cuts has had a positive impact on risk assets, including fixed-rate junk bonds.
Increasing Investor Interest in High-Yield ETF Funds
High-yield ETF funds have experienced significant investment inflows. In the week ending December 6th, investors injected an additional $1.5 billion, resulting in a remarkable 72% increase compared to the previous week. This marks the sixth consecutive week of inflows, according to CreditSights.
Shifts in Investor Allocation
In recent weeks, investors have shown a preference for corporate high-yield funds while reducing their exposure to inflation-pegged TIPS funds, government securities, and Treasury investments, as reported by BofA Global data.
Managing Volatility in the U.S. Bond Market
Over the past two years, rates volatility in the U.S. bond market has caused significant disruptions. However, there is hope that the worst impacts of the Federal Reserve’s aggressive rate hikes since 2022 may be behind us.
Positive Performance in Stock Market
On Friday, the Dow Jones Industrial Average (DJIA) climbed 116 points (0.3%), narrowing the gap towards its record close from two years ago. The S&P 500 index (SPX) and the Nasdaq Composite Index (COMP) also saw gains of 0.4%, according to FactSet.
Read: Investors are taking more risk as we near the end of 2023