March 6, 2020
It is difficult to characterize the volatility seen in fixed income over the last few days as anything but extreme. Having started the week at a yield of 1.67%, the 30-year Treasury briefly traded below 1.20% on Friday. Perhaps more alarmingly, the bid-offer to trade government long bonds increased more than 5-fold while the size dealers were willing to trade decreased by about 10 times. Meanwhile, investment grade corporate bonds spreads are starting to gap wider as trading has become less orderly in the last few days. Indeed, many energy bonds were 30-40 basis points wider on Friday—which is about 10 times their average daily move. No doubt, many are asking what exactly went wrong this week.
The obvious answer to what has changed in the last few days is that Covid-19 continues to spread within Europe and the US. Multiple community outbreaks on the West Coast have increased the concern among the public and made it more likely that efforts to contain the virus will not be successful. The fact that Covid-19 testing kits are only now becoming available and are still in short supply makes it likely that many more cases will be discovered in the coming days and public concern will increase even further. In the coming days, we expect that the US will begin to implement more widely some of the social distancing measures adopted by other countries. More corporations are likely to ask their employees to work from home; schools may close in communities with confirmed cases; and large entertainment events could be canceled.
As the measures taken to halt the spread of the virus become more prevalent, the probability that the US and several European countries enter recession is rapidly becoming the base case scenario. Consistent with that view, interest rates in the US now imply that the Fed will cut the funds rate to zero this year. Indeed, it may be that the incredible rally in long-end Treasuries is the result of foreign buying predicated on the belief that hedging-costs (mostly dictated by Libor) are poised to decline substantially. If the gap between Fed and ECB monetary policy is in the process of closing, it makes sense that the gap between long-end Treasury and Bund yields will narrow as well.
No doubt, when the Fed cut rates by 50 basis points intra-meeting on Tuesday, they probably did not anticipated markets reacting as they have since. One reason that the Fed’s actions were not take more positively by market participants is that they have proven to be unilateral so far–except for Canada. To the extent that central banks can ease financial conditions while the virus is still spreading, investors are looking for global coordination. While it was disappointing that such a coordinated response did not follow the Fed’s cut this week, it is not too late for more actions. The ECB meets on Thursday March 12; the Fed is on Wednesday March 18; and the Bank of England is on Thursday March 26.
To be fair, central banks are in a tough spot. In recent years the Fed has argued that with their rate-cutting ammunition limited by the zero lower bound, they must be more proactive to ease. In other words, the Fed is inclined to do an emergency cut in situations like these because they cannot cut by 250-350 basis points as is typical heading into a recession. At the same time, the Fed is wary of providing too much stimulus relative to the severity of the economic shock. If Covid-19 concerns were to recede in a month or so, lower oil prices and the decline in mortgage rates could quickly overheat the economy.
The difficulty in calibrating the central bank response seems to be contributing to a muddled message from the Fed and ECB. For instance, James Bullard, the President of the Federal Reserve Bank of St Louis, tried this week to play down expectations of further cuts at the March meeting of the Federal reserve after the 50 basis point emergency cut. Likewise, there have been ample opportunities for members of the ECB to talk more supportively, but it would seem that the committee is not focused on doing much beyond a 10 basis point rate cut and making modest tweaks to the TLTRO program.
As we look ahead to next week, watching whether central bankers change their tune will be just as important as watching the spread of Covid-19. In LGIMA credit portfolios we remain modestly underweight risk and as such the portfolios continue to perform reasonably well throughout the current volatility. At the LGIMA March strategy meeting on Tuesday, we elected to stay underweight until spreads widen further to incorporate the risk of recession in the US.
That being said, as investment grade spreads go wider, we continue to look for opportunities to add dislocated lower-beta bonds. One byproduct of the fall in interest rates is that the spread on many A-rated bonds have widened substantially as they tend to be bought by yield-sensitive buyers. In many cases, the yield on these bonds has not changed much in the last two weeks, which means that the spread widening has been inversely correlated to the fall in interest rates. Some sectors where we have added A-rated risk include banks, sovereigns, energy, and utilities. In a few cases we have engaged companies directly to encourage issuance at levels that are wide to the secondary market. We are not adding BBB-rated risk at this time.
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