Credit spreads rallied in October due to a combination of improving economic data, low inflation and the prospect of US corporate tax reform.
Economic data came in much stronger than expected in October. The Citi Surprise Index which measures data surprises relative to market expectations, increased to +40.90, a dramatic reversal from June 2017 when it was at -78.60 (see chart below). Most encouraging was the fact that, unlike earlier in the year, the improvement was not just limited to the "soft" survey data like consumer confidence, Institute for Supply Management surveys and regional Fed surveys. "Hard" indicators like auto sales, industrial production and GDP were also strong during the month with the hurricane recovery efforts providing a bit of a tailwind. The one area that continued to come in below expectations was inflation.
Inflation continues to be stubbornly low, confounding most economists given tight labor markets usually lead to wage pressures. However, the lack of inflation has given both the ECB and the Fed the flexibility to only gradually remove their historically accommodative monetary policy stances despite strong economic growth, creating an environment that is very supportive of credit spreads. To this end, the ECB delivered a dovish message during its meeting on October 26th when it extended its monthly purchases until September 2018 at €30bn/month and guided towards a negative policy rate beyond the end of QE. Furthermore, Draghi remained committed to the corporate bond purchase program. Similarly, the Fed continues to be slow and deliberate in its tightening cycle, leaving rates unchanged this month, but signaling that a December increase is likely. While a newly appointed Fed Chairman Powell is likely to be somewhat less dovish than his predecessor, a low inflation environment will likely continue to dictate a gradual path of monetary policy tightening in the first half of the year.