September was an extremely strong month for investment grade credit as the market seemed to focus on all the positives (tax reform and the rebound in oil) and looked through the negatives (geopolitical tensions, central bank tapering, somewhat surprising German election results and natural disasters). While we certainly welcome the positivity, which feels particularly important in this day and age, the asymmetry of the bond market leads us to start with the negatives.
Geopolitical tensions continued in September as President Trump and Kim Jong-un exchanged threats throughout the course of the month regarding North Korea’s nuclear ambitions. Traditional diplomacy was replaced with personal insults. North Korean missile tests were met with additional US economic sanctions. This was followed by North Korean threats to test a hydrogen bomb in the Pacific Ocean and a statement from a North Korean foreign minister that the US had declared war and therefore intended to shoot down any US airplanes even in international airspace. Despite the escalating rhetoric, there was little reaction in credit spreads as most market participants believed that cooler heads would prevail and viewed a nuclear conflict as an unlikely tail risk.
Central bankers were also busy during the month laying out their plans to unwind the unprecedented monetary policy experiments referred to as quantitative easing. As expected, the Federal Reserve announced that it would start to normalize its $4.5 trillion balance sheet in October gradually reducing the reinvestment of proceeds from maturities. While the European Central Bank has yet to make its plans officially known, it is expected to announce tapering of its own during its next meeting on October 26th. We believe the ECB announcement has the potential to have more of a negative impact on spreads since the corporate bonds were included in the purchase program. However, our base case is that the spread impact will be limited as both central banks have adequately prepared the markets for these announcements. The risk is that the ECB comes out much more hawkish than anticipated which would cause both government yields and spreads to sell off. Provided the ECB maintains their dovish tone and tapers in a gradual manner, the market should be able to absorb the announcement without significant volatility.