- As the only market among G3 sovereign bond markets offering positive yields, US bonds have been the principal destination of capital flows seeking a safe haven since the start of March.
- US bond yields have plummeted to historic lows, suggesting investors anticipate deflation will result from a simultaneous supply/demand shock in the wake of the coronavirus outbreak.
- With bond yields in Japan and the eurozone already negative, these events raise the prospect of G3 bond yields converging at zero (or below).
The first week of March was eventful, to say the least
The OECD had previously warned that a prolonged outbreak of coronavirus could halve the forecast global growth rate from almost 3% to 1.5% in 2020.
Hours later, after a conference call, the Federal Reserve’s Open Market Committee (FOMC) announced an inter-meeting interest rate cut of 50 basis points (0.50%), taking the federal funds target rate to 1.00 – 1.25%.
The FOMC declared that while “the fundamentals of the US economy remain strong” the spread of the coronavirus “poses evolving risks to economic activity”. It was the first inter-meeting rate cut since October 2008.
With yields in the eurozone and Japan at or below zero for almost all bond maturities, only the US Treasury market offers both safe haven status and positive yields. These may not be available for much longer. US bond yields are have fallen to levels with no historical precedent.
Exhibit 1: G3 bond yields to converge at zero? - graph shows the US, Japanese and eurozone yield curves as of 09/03/2020. For the first time ever yields on US Treasury bonds are below zero at all maturities along the yield curve.
A regime change in oil markets
On Friday 7 March, talks between OPEC and Russia over whether to cut oil production in response to the coronavirus collapsed without a deal, sending oil prices into freefall.
The fall in prices of Brent and West Texas Intermediate accelerated on 9 March. At one stage they were down 30% before recovering to end the day down 20% in European trading. This is the most severe sell-off in oil markets since the first Gulf war in January 1991.
Previous falls in oil prices were seen as a clear positive for the global economy, putting cash in consumers’ pockets and reducing costs for industry. It equated to an income transfer from oil producers to oil consumers with winners and losers.
A disinflationary oil shock
In the current environment the precipitous fall in oil prices and associated geopolitical issues (e.g. an absence of global policy coordination) are more likely to have a negative impact on the global economy. Consumers are more likely to save than spend any windfall gains in disposable income. Similarly airlines are unlikely to reap the full benefits of lower oil prices in coming weeks.
Capital expenditure in oil-related sectors and oil-producing countries (around 40% of emerging market sovereign credit indices) is likely to fall.
Stress in US credit markets will likely be aggravated. With a significant segment of US investment-grade bonds BBB-rated and at risk of downgrades, the negative consequences are likely to be at least comparable to those following the 2015/2016 fall in oil prices (shale oil producers make up around 12% of the US high-yield bond index).
Deflationary pressures unleashed
The combination of a simultaneous supply/demand shock resulting from the coronavirus epidemic followed by a crash in the oil price represents a major shock to the global economy.
Risks of a 'credit crunch' leading to a full-blown global recession have risen significantly. In the absence of concerted policy measures, companies will likely face liquidity constraints due to an abrupt, but temporary fall in business activity, although their prospects for longer-term solvency should be good.
If short-term financing is unavailable, the risk of a vicious cycle of bankruptcies arises. This is probably the main explanation for the severity of the current sell-off in risky assets (the S&P 500 index fell 8% today, while the pan-European STOXX 600 index closed down 7.4%, its worst day since the 2008 -2009 financial crisis).
Central banks will do what they can
Central banks and governments are cognisant of these risks. We anticipate that they will do what is necessary to mitigate risks of a credit crunch. A coordinated and determined policy reaction could bring relief.
Central banks are likely to support future fiscal measures. We expect the ECB to announce on Thursday 12 March (or even before if market conditions deteriorate further) targeted measures to provide liquidity to troubled companies and lower its deposit rate to -0.60% (a cut of 10bp). The primary objective of a rate cut would be to prevent a tightening of financial conditions via an excessive appreciation of the euro in currency markets.
In the US, markets are pricing (and we agree) another cut in the federal funds rate of at least 50bp at the monetary policy meeting on 18 March.
In our view, it is now probable (as markets are pricing) that the FOMC will cut the federal funds target rate further in coming months to 0.00-0.25%, the level seen in the wake of the 2007/2008 financial crisis.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.