Fed Chair Powell said, in what could probably be his most memorable quote, “We are not even thinking about thinking about raising rates”. Given the sharp contraction in activity and employment over the last couple of months, central banks moved to a lower for the longer regime, with the explicit goal of returning to pre-COVID levels of aggregate demand, whatever be the cost.
The effects of this regime on markets are wide. On one hand, yields on short term bonds are likely to be stuck trading in a very narrow range for a considerable amount of time, leaving the long end to do all the work, steepening or flattening. On the other hand, low volatility will be good for risk assets like stocks, which benefit from low and stable borrowing rates, which, by itself can also influence long end bonds. Let's look at the dynamics driving the long end rates in more detail.
Treasury supply, especially at the long end is increasing rapidly, a corollary to their plans for the economy. The Fed is also buying a substantial amount of these bonds, but their purchases are distributed across the curve. This mismatch could put some pressure on the long end bonds, and the yields could rise, in a move that would be described as bear steepening. However, this is just supply. When the appetite for risk is low, the market can absorb all the supply as it looks for a safe place to park excess cash. Therefore, we have to analyze demand as well, and we can do that by looking at the general risk sentiment – reflected in stocks, currencies, metals and macroeconomic data such as inflation and growth.
Stock markets had staged an unimaginable recovery since their March lows. They broke through all kinds of technical levels, confounding both valuation purists and those using macro frameworks to categorize assets as risk-on or risk-off. That was until last week, when the rally finally lost steam, dragging stocks lower by 8% (S&P 500) wiping out trillions in wealth. Two questions matter from here on:
1. What changed over the last week to drive the sell-off?
2. Will there be buyers at current levels for the stocks or is the rout likely to continue?
For the first, the answer is – nothing. People justifying this are rallying on central bank's expansion of balance sheets, fiscal support and the existence of some large tech firms which are the favorite growth plays for investors worldwide – and none of that has changed. We have no new material information today that we didn't have a week or even a month ago. Infections were still rising in the US and around the world at an uncomfortable pace, valuations were still expensive, the unemployment rate is not expected to fall back to pre-COVID levels by the end of this year, nor was anyone expecting a vaccine too soon.
So, it could have been a sudden realization of the risks we face or simply markets taking a break. Given that this sell-off was not in response to bad news that is now priced in and the relatively expensive valuations at which stocks trade in general, we can conclude that there won’t be big buyers unless we see more discounts getting priced in.
However, one can’t write the bulls off entirely since institutional investors who missed the rally might want to initiate participation at this point. But if it does move down further, markets might come to form a W shaped recovery instead of a V-shaped. One factor that should keep this sell-off limited compared to March’s one, is that many central bank and fiscal programs are already in place, which means those who need help can raise money relatively quickly. So, liquidity (or the lack of thereof) won’t kill the market this time, yet solvency might do so if the economy fails to reopen as the markets expect.
Currency markets have also seen the Euro outperform both USD and CHF recently, a sign that the EU is on track for a recovery. For commodities, copper has given up some of the gains that it has accumulated in the last few days but is certainly up a long way from the lows made in March. Although there are some idiosyncratic factors involved in both these assets, it is usually considered a good sign for global economic growth. Since the central banks have continued to protest the idea of negative rates and hikes are also ruled out, the potential for movement in the yields around the belly of the curve is relatively limited. This means that outsized moves in currency and metals might lead to the change in sentiment from risk-off to risk-on.
Lastly, macroeconomic data has been subdued and is unlikely to bounce back very soon. It is important to note that a jump in growth rates is not enough – rather, we need an indication that demand is back on track to meet the pre-COVID trend growth for a long end to sell substantially.
Overall, the long end of the bond market will find useful guidance from the price action in these other markets. Here, the factors that could tip the scales between V and W (and for that matter L, U or S) are worth repeating:
1. Vaccines and significant improvement in health
2. An overwhelming increase in fiscal or monetary support in the US
3. Continuous recovery in employment
Looking forward, two big camps are emerging in the market space – one which argues for debt, depression and disinflation while the other calling for hyperinflation. The first camp gets its argument from the experience of the last decade, when central banks failed to generate inflation. The second camp is looking at supply chain disruptions, deglobalization, and a sharp rise in money supply, leading to inflation. Even though the world has been in a secular disinflationary environment for a while, certain aspects of this recovery would make it different from the previous one. Some of those differences are:
1. There is no apparent hurry to tighten the purse as far as government spending is concerned – austerity has certainly taken a backseat.
2. Central banks have realized that there is no such thing as NAIRU and even if there is one, it is much lower than previously expected.
3. The nature of the crisis helps mitigate the question of moral hazard, which allows the policymakers to step on the gas without having to worry about being answerable to Congress.
This “whatever it takes” stance of policy should be able to support recovery assuming positive developments on the virus and vaccines, although it is unlikely to be the kind of V that investors have been expecting. As a trading strategy, finding dislocations between assets that can be characterized as inflationary/disinflationary and risk-on/off should be the safest bet.
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