Market volatility continued last week and into today as financial markets are responding to a number of developments including the rise in cases of COVID-19, the quarantine of Northern Italy (and the potential for similar actions to be taken in other geographies), and a collapse in energy prices after a deal to limit oil production between OPEC+ members fell apart.
Like past market disruptions such as 9/11 and the financial crisis, the outbreak of COVID-19 is driving tremendous fear and uncertainty, two things that financial markets loathe. We know that the virus is spreading in what has become a globally connected world, which will slow economic activity for the next several quarters. It is likely that shallow recessions will emerge this year in many economies around the world.
Importantly, as we discussed last week, investment-grade bonds continue to do their job as an historically stable asset class that has provided negative correlation against riskier assets in times of market stress.
US Treasury and Government Securities
US Treasury yields have fallen sharply as investors around the world seek safety and security and the Federal Reserve lowered the fed funds rate (FFR) by 50 basis points last week. Currently, the entire Treasury curve is yielding less than 1% as investors are pricing-in additional monetary easing. After the Fed’s latest move, the target range for the FFR is 1.0-1.25%. Investors are currently pricing-in another 80 basis points of easing by April, which, if realized, would effectively take the rate back to the zero bound. The question on additional FFR cuts is not a matter of if, but when. The FOMC’s next official meeting is next week, but as we saw last week, the Fed may not wait to take action.
What we are watching: Based on where long-term Treasury yields are currently trading, the market is anticipating not just an FFR cut, but also a new quantitative easing (QE - i.e. bond buying) program. Unlike the European Central Bank, the Fed has expressed an unwillingness to take the FFR into negative territory. If this stance holds, and the FFR is lowered to the zero bound, additional QE is the natural choice to further ease monetary policy. Of course, a lowering of the FFR and additional bond buying does nothing to get quarantined workers back on the job or solve for supply chain issues. However, the Fed’s goal would be to ease financial conditions and keep credit flowing in order to not exacerbate the economic weakness.
Friday marked the first day that we saw meaningful weakness in the US corporate bond market as credit spreads (a measure of corporate credit risk) widened significantly and liquidity was challenging. Spreads continue to move wider this morning, particularly in the energy sector with oil trading down 20-30%.
What we are watching: Spread levels are quickly approaching those last seen during December of 2018, which was the last period of any significant credit stress. During that time, investors were pricing-in economic weakness as the Fed had just raised the FFR multiple times and indicated further rate hikes in the coming year (before ultimately reversing). While this environment is certainly different, as we discussed last week, we are selectively mocking-up trades to increase our exposure to certain parts of the corporate market as valuations in our view, are becoming compelling.
Municipal bonds tend to operate with a lag and last week was no different. Typically, when we see sharp moves in Treasury yields, municipal yields take a few days or weeks to “catch-up,” as price discovery in this over-the-counter market can take some time. As we type, municipal yields are projected to fall ~10 basis points across the curve today, which represents a nice rally, but not to the same extent as Treasurys.
What we are watching: Thus far, credit spreads in the municipal market have largely held steady and the lag versus Treasurys has been consistent across rating categories. Interestingly, last week broke the streak of inflows into the muni market as investors pulled money from municipal funds for the first time since early 2019. Given the technical nature of the market, we are watching to see if fund outflows create any type of credit dislocation, which would be a more ominous sign for future relative performance.
Portfolio Construction – Anything to do?
In the last few days, we have fielded questions around whether a change in portfolio strategy is warranted given the move in rates and diverging sector performance. We would encourage clients and advisors to take this opportunity to review their investment strategy and remind everyone that we offer several strategy options designed to meet several needs and outlooks. While we don’t expect interest rates to immediately reverse and move back to levels where we started the year, should clients choose to reduce interest rate risk we can certainly accommodate a duration strategy change, which would be done thoughtfully to reduce any negative tax impacts. Should a client wish to increase corporate exposure, we can, for example, switch from a Tax-Free strategy to a Tax-Aware strategy, which will introduce corporates into the allocation.
Source: Bloomberg, ICE BofA
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