There’s No Map for Rates Investors Plotting a Course to Recovery
Rates investors grappling with this crisis are strategizing for the recovery -- but it may not be much easier to trade.
On the face of it, the playbook seems straightforward. Central banks globally are smothering volatility and driving yields lower with massive asset purchases and other programs -- including the $2.3 trillion of support the Federal Reserve tossed into the mix Thursday.
Just like in the aftermath of the 2008 crisis, this creates a strong case for ditching government debt in favor of riskier assets. But timing such a move around the uneven spread of a pandemic, uncoordinated waves of global government spending, a flood of bond supply, and the risk of mounting corporate defaults -- not to mention skittish market sentiment -- is fraught.
A hint of how fast sentiment could turn came last week, as signs that the virus’ spread may be slowing in American hotspots helped propel U.S. stocks back into a bull market. So far Treasuries have seemed almost impervious to that optimism. The market sold off a little -- a nod to the Trump administration’s goal of reopening the economy in a matter of weeks-- but since March 23, which marked the low in the S&P 500, government bonds have actually gained.
The benchmark 10-year yield is down 7 basis points over that period, ending the week at 0.72%, more than a full percentage point below its New Year’s Eve close. For the time being, it’s hard to find anyone who wants to offload lots of Treasuries, though they’re alert to how quickly their positions could sour.
“You’ve seen a rally in Treasuries which has been explosive,” Western Asset Management’s Ken Leech said in a conference call Tuesday. For investors in long-dated bonds, the chief investment officer said, “you have a tremendous amount of risk if things get better -- the front end of the curve is safer.”
The Treasury curve showed that last week with a steepening move fueled by selling in long-dated bonds. That’s widened the gap between the two- and 10-year yields by 16 basis points from its narrowest point this month, to 49 basis points.
Leech conceded his portfolios, built on the expectation of stronger growth this year, were sideswiped by the market chaos caused by the pandemic. He isn’t about to get caught on the other side by a rebound in risk appetite. He says the Fed’s actions should anchor the front end of the Treasury curve.
A further rally in U.S. government debt certainly can’t be ruled out, driving long-end yields back to, or below, March’s historic lows. Bank of America technical strategist Paul Ciana reckons a 10-year yield of zero to 0.25% is “reasonable” in the second quarter assuming that coronavirus-related quarantines, social distancing and medical advances are effective. A worse case could even see the benchmark drop below zero, in his view.
But with yields already so low, many see little more to gain from the Treasury market. High-quality corporate bonds are the clear favorite among investors now -- in a market flooded with record issuance -- as the Fed has pledged its support with unprecedented direct purchases. Ed Al-Hussainy at Columbia Threadneedle has pared his Treasury positions and “swung really hard to credit,” although he’s willing to buy 10-year government debt when the yield on it approaches 1%.
It’s straight back to basics: Don’t fight the Fed. Though even the blue-ribbon credit market is not without its risks: Morgan Stanley estimates that as much as $350 billion worth of bonds could lose their investment grade ratings this year.
Inflation-linked bonds are a popular recovery asset of choice for money managers like Chris Dillon at T. Rowe Price, who anticipates a world of broken supply chains and flooded with stimulus. The recovery in breakevens -- the Treasury market’s gauge of inflation expectations -- suggests an outright deflationary spiral is at least less of a risk.
“We think of de-globalization, global supply chains getting reconfigured -- when demand gets back on line, we could certainly see spikes of inflation,” Dillon said.
For now, rates seem embarked on a far less thrilling course than their haywire trajectory of the past month, and rangebound is the operative framework, according to BMO Capital Markets. The firm’s strategists expect the benchmark yield could ply the 33-basis-point channel it’s been in since March 23 -- capped at 0.89% -- for weeks to come.A foray above 1% would take “a concrete reopening schedule and significant progress in battling Covid-19 in the U.S.,” they said.
That restraint contrasts with last month’s 96-basis-point range, and it reflects the enormous weight of central bank purchases. Estimates for where the Fed’s balance sheet will end up as we work through this crisis are as high as $10 trillion, from close to $6 trillion now.
“Yields will have a tough time moving meaningfully upward here even in the case that we start to have a recovery,” said Alicia Levine, chief investment strategist at Bank of New York Mellon. “Ultimately we think this disruption is going to be very deep and not so easy to return from.”
What to Watch
Federal Reserve officials are webcasting:
April 14: St Louis Fed’s James Bullard holds a Covid-19 briefing via Zoom; Chicago Fed’s Charles Evans speaks in Pittsburgh
April 15: Atlanta Fed’s Raphael Bostic addresses Birmingham Rotary and Kiwanis clubs via Zoom
Here’s the economic calendar:
April 14: Import and export prices
April 15: MBA mortgage applications; retail sales; Empire manufacturing survey; industrial production; capacity utilization; business inventories; NAHB housing market index; Fed Beige Book; TIC flows
April 16: Housing starts; building permits; Philadelphia Fed business outlook survey; initial jobless claims; Bloomberg consumer comfort
April 17: Leading index
The auction slate is focused on bills:
April 13: 13-, 26-week bills
April 16: 4-, 8-week bills