- The Fed’s policies have helped curb volatility in Treasury and other credit markets.
- Global stimulus has yet to create an oversupply of bonds or inflationary pressure.
- We expect to see downside risk to yields as economic recovery will remain sluggish.
There has been a lot of volatility over the past month in the global rates markets. Government bonds are trading at close to, but above, recent lows as of early April. The benchmark 10-year U.S. Treasury yield was around 0.64 % in mid-April after reaching an all-time low of 0.31% on March 9. In Germany, the yield on the 10-year government bonds (bunds) was around -0.47% compared with a March 9 low of -0.9%. In Japan, the 10-year government bonds (JGBs) were yielding -0.01 % from a March low of -0.19% and -0.2% in early October 2019. In the United Kingdom, the 10-year bonds (gilts) yielded around 0.30% compared with a March 9 low of less than 0.2%.
The Fed’s unlimited firepower
We analyze several factors to determine the trajectory of global yields. The first is whether the Federal Reserve has done enough to curb volatility in the Treasury market. The answer is yes. Some of the Fed’s key facilities are only now getting up and running. The dealer community remains nervous. However, we draw comfort from the size of the Fed’s balance sheet, its clear willingness to use it, and its determination to continue offering different facilities until it calms down key markets. The Fed has lowered short-term interest rates to nearly zero, and plans to buy Treasury securities, agency mortgage-backed debt, and corporate bonds. Beyond that, other measures include the Money Market Mutual Fund Liquidity Facility (MMLF) and the Primary Market Corporate Credit Facility (PMCCF) to support the flow of credit.
We draw comfort from the size of the Fed’s balance sheet, its clear willingness to use it, and its determination to continue offering different facilities.
We also wonder if the Fed will effectively socialize private debt. If all private debt gets put on the Fed’s balance sheet, which is backed by Treasuries, then credit risk will disappear, and all debt will become public debt. For spreads to collapse to zero, the yield on existing Treasuries would rise, just as the yield on private debt would fall, and the yield on the new stock of Treasuries would be higher. So far, this has not happened, but we cannot rule it out.
Rising supply and fiscal policies
Do the global fiscal responses threaten an “oversupply” of bonds, an increase in inflationary expectations, and upward pressure on rates? We believe the answer is no.
The U.K. market may be the best evidence of this, at least in the short term. The Bank of England and Prime Minister Boris Johnson’s government stepped up their responses to the pandemic. The government will pay a large part of workers’ salaries as long as companies keep their employees, mirroring policies adopted by other European states. The BoE also cut interest rates and will undertake large-scale asset purchases. The large fiscal package and the dramatically higher borrowing requirement have not had much of an impact on government bonds (gilts) even though the country will need to attract global capital to finance itself. The pound sterling’s role as a reserve currency is very much a second-order role.
In the case of the United States, another way to think about this is to ask who is going to buy the fresh $2 trillion (give or take a few tens of billions) in Treasury issuance? In the aftermath of the 2008–2009 financial crisis, the expanded issuance was heavily bought by foreign central banks and money market funds. This time around, the same players will feature, and we must not forget the Fed. Quantitative easing (QE) does not allow the Fed to buy directly from the Treasury. However, you can expect the Fed to adjust its QE program to prevent any potentially disruptive move in yields. In the longer run, if we get a rapid economic recovery and an associated rise in private demand for capital, then we will have to revisit this issue, but that is not a near-term problem.
The rates path
What is the economy’s likely trajectory? As we mentioned in our recent blog, an extremely sharp global downturn is unfolding and the U.S. economy is heading into a recession as the coronavirus pandemic takes a toll on economic activity. That said, things could turn out better or worse.
We are in the “sluggish recovery” camp.
We are in the “sluggish recovery” camp. That makes us think there is downside risk to rates in the near term because the macro data will look terrible for a month or two. We expect only modest upside risk to rates over the second half of 2020 as the economy will struggle to regain its footing.