At the beginning of March, shortly after markets embarked on what would, within three weeks, become one of the worst risk-asset routs in history, Deutsche Bank’s Aleksandar Kocic wrote that during demand shocks (or expected demand shocks), “the underlying mode of the market is characterized by increasing coordination between rates and risk assets”.
Equities, for example, fall, and rate cuts “act as a parachute that slows down the fall”. The effectiveness of the “parachute” is simply the relative speed of the decline in risk assets (in this case, SPX) per unit of yield change.
If rate cuts are effective, the speed of the decline is slower. If, however, “rate cuts are ineffective, e.g. the recession is too deep that rate cuts cannot slow down selloff in risk, like in 2008, the drop in equities per unit of yield decline is large”, Kocic went on to say. Here are some historical examples:
Suffice to say the parachute wasn’t very effective last week, and especially not last Monday, when US equities plunged the most since 1987 following the Fed’s Sunday evening 100bps emergency rate cut (accompanied by the rollout of myriad other measures aimed at supporting liquidity and ensuring the public health crisis doesn’t morph into a financial meltdown).
This is, simply put, a case where risk assets have clearly decided that rate cuts (and monetary policy in general) isn’t going to be sufficient in the face of what many now project will be the worst economic downturn for the US since the Great Depression (even as it’s expected to be fleeting in nature).
Goldman’s call for a 24% Q2 contraction was a chyron on CNN Sunday, underscoring the notion that the depression meme has gone mainstream.
“Market’s reaction reflects a perception of highly asymmetrical outcomes: Downsides are bottomless and upsides incremental and tentative”, Deutsche’s Kocic wrote Friday, in his latest note. “This is seen through a jagged downward trend in risk – a forceful selloff followed by a careful and anemic rebound in response to continuous arrival of new installments of (unprecedented) stimulus measures”.
But there has been no real “trend”, per se, in rates since March 10. Rather, we’re now caught in the policy mix crossfire – “from parachutes to helicopters”, as Kocic puts it.
“As long as it has been about monetary policy alone, risk and rates have been responding in unison, both lower in a coordinated way”, he goes on to write, before noting that once the Fed slashed rates to zero and announced $700 billion in new QE, a trio of factors conspired to make the long-end wholly unpredictable.
First is obviously the expected fiscal response. Naturally, market participants are pondering the prospect of a supply increase to fund trillion-dollar rescue packages.
Second, Kocic flags the forced liquidation discussed in these pages at length last week. “The intensity of the credit move caused massive unwinds and losses indirectly forcing the selloff in the UST (the best performing asset thus far) in order to cover losses and redemption costs”, he says.
Finally, it’s not longer clear whether USTs make sense as the go-to safe haven. After all, yields arguably overshot to the downside, and on top of that, how does one feel comfortable owning a 10- or 30-year bond in the face of what may ultimately be multi-trillion dollar deficits financed in effect by keystroked money? As Kocic puts it, “the uncertainty about the duration of the crisis and its final outcome, together with the size of fiscal stimulus raised the questions about bonds’ suitability as a choice for safe haven”.
Indeed. Over the course of the last week+, there have been several days when bonds failed to diversify or otherwise “offset” large losses in equities, leading to huge drawdowns (on some days) in simple balanced portfolios.
The read-through for risk parity wasn’t good, to say the least (see here and here). “The forces outside of monetary policy became an indirect assault on [the] risk parity trade which, in the absence of additional good news regarding the pandemic, threatened to become self-reinforcing”, Kocic adds, weighing in briefly on the unwind.
There isn’t likely to be much in the way of relief in terms of wild daily swings for bonds, which will remain prone to selloffs on confirmation of massive stimulus, and inclined to rally sharply on days when the news around the virus (the proximate cause of the stimulus push) is particularly bleak.
And then there’s the supply that’s already coming online. “Roughly $340 billion of Treasuries are on the way”, Bloomberg wrote over the weekend, adding that while “that burst of supply could help a market starved of high-quality securities if it lands in less chaotic conditions, there’s hardly any guarantee of that [given] the 10-year yield… swung in a range of more than 50 basis points in each of the past three weeks, a phenomenon that hasn’t been seen in the past two decades”.
Oh, and don’t forget about liquidity. In short: There isn’t any. Work from home arrangements and other efforts to separate people could conceivably make the situation more acute. Consider this brief excerpt from JPMorgan’s Josh Younger, for example:
Though we have yet to see how broadly and acutely the economic consequences of the COVID-19 outbreak will be felt, pervasive remote working arrangements could impact market operational risk. We are already potentially seeing the first signs of disruption in reduced dealer risk-taking capacity. We show in Exhibit 7 that market depth has already fallen considerably—especially in the long end, where it is worse than 2008 levels—but there are some signs of more troubling cracks in market making. Recent acute, intraday episodes of stressed liquidity have been reminiscent of the “Flash Rallies” of 2014 and portend a further deterioration in orderly price action to come. In principle, one would expect the high-frequency trading activity (HFT) that dominates liquidity provision in interdealer Treasury markets to be more resilient in a WFH construct—it is automated after all. However, these traders are also notoriously skittish when volatility spikes. Though “human” traders have typically provided a backstop in prior episodes, WFH and split working arrangements likely introduce new frictions owing to potentially inefficient communication and systems issues. If that occurs we believe this particular circuit breaker will not function effectively, which could significantly extend the vicious cycle of higher volatility begetting lower liquidity, and so forth. Among other things, this means significantly higher transaction costs, even for benchmark Treasuries are possible.
How things play out in the near-term against this rather daunting backdrop (in which rates are pulled one way by a crisis and the other by the response to that same crisis), is anyone’s guess – especially when liquidity is severely impaired.
Given the indeterminate nature of the virus’s evolution, any policy response risks being inadequate or too aggressive.
“Crisis can be too long — the longer it lasts the deeper it becomes, possibly rendering stimulus, no matter how massive, inadequate”, Deutsche’s Kocic goes on to write, adding that if, on the other hand, “everything is over relatively quickly, we could end up with overstimulated economy in recovering markets”. Clearly, those two outcomes would have vastly divergent ramifications for rates and the curve.
Of course, for right now, no one cares about the long-term. “There is little attention to anything beyond immediate future”, Kocic says. “It is all about surviving the short-term”.
That applies both to markets, and in a more general (i.e., a literal) sense.