“When you live in hysteria, people tend to think emotionally.”
While the stock market gets most of the headlines, the recent price action in the bond market has been breathtaking. To most people, the bonds are both boring and obscure. Bonds? Shoot, invest your money; collect your interest, and get your principal back when the thing matures. Right? In a lot of ways, I suppose that really is about it, at least for the average investor or “man on the street.”
However, more than just a boring investment for old people, bonds represent the price of money in the US economy. The price of money is supposed to reflect the markets’ expectation for future inflation. Conventional wisdom suggests inflation is a function of economic activity. If not a true function, there is at least a pretty strong positive correlation between the two.
So, when interest rates are high, you can reasonably intuit the markets believe inflation will be higher in the future, quite possibly due to increased economic activity. When rates are low, you can expect the opposite. Of course, a finance professor or a slick-haired bond trader would argue there is ‘more to it than that,’ and there is. However, for cocktail party conversation purposes, interest rates reflect the price of money in the economy, and economic activity usually determines the price of money.
So, there is a measure of disquiet in watching the US Treasury market rally like it has over the last couple of weeks, ostensibly due to the fear (or near hysteria) surrounding the COVID-19. This global flight into US debt has caused yields/interest rates to fall to all-time lows, again, all-time lows. At 2:14 pm CST on March 6, 2020, the yield to maturity on the 10-Year US Treasury Note was 0.700%. That is right, 0.700%. It had been 1.877% to start the year. For its part, the 30-Year US Treasury Bond, had a yield to maturity of 1.206% at the same time today. It began 2020 at 2.316%.
Shoot, both securities started the WEEK at 1.150% and 1.676% respectively. For those of you not overly familiar with the bond market, these are significant moves in a compressed period of time. Further, they are even more significant when you realize these rates didn’t approach these levels in 2008, when the world’s financial system was falling apart.
The question is then: do investors really think COVID-19 will cause an even greater economic recession than 2008? The answer is maybe, but probably not. You will have to indulge me here.
What happens when the weatherman predicts snow in the Deep South? What do people do? If you live down here, you already know the answer(s). You go to the grocery store to load up on: 1) milk; 2) peanut butter; 3) bread; 4) Cokes; 5) batteries, and; 6) for reasons only we understand when it is, literally, freezing outside, ice. Then you hustle over to the state store to get: 1) bourbon, and; 2) again with the bourbon.
I am not kidding when I tell you I have been in a Publix grocery store the afternoon before local meteorologist James Spann predicted a snowfall of “up to 1 inch” and could only find a package of onion kaiser rolls and a quart of buttermilk, which is nasty stuff by the way. This at a major grocery store, not a gas station. Had you been standing outside selling loaves of Nature’s Own Honey Wheat for $10/per, I would have taken three, such was the mania and my desire to show up at the house with something on the list.
However, you weren’t, so, if memory serves, I got some flour tortillas, one of the last packages of American “cheese” singles, and a nice bottle of chardonnay to placate the lady of the manor. The latter worked, and the hotly anticipated weather catastrophe never quite materialized. Regardless, all the schools were closed the next day, and more than one person around the area could be heard to say: “I can’t believe we have to be here at work today.” All of this over the threat of an inch of snow. Seriously.
Panic makes people do strange things.
Obviously, panic has recently come home for dinner. After all, US stocks were hitting all-time highs just a couple of weeks ago or so. To be sure, yields had been inching down ever so slowly since the start of the year, but it had all been relatively orderly. Lower yields beget higher stock multiples, and all of that, so all was right with the world…until it suddenly wasn’t.
The fit hit the Wuhan (like that?) on Monday the 24th, when the Dow Industrials fell over 1,000 points after a particularly gloomy weekend involving COVID-19 spreading rapidly OUTSIDE of China, most notably in Italy. Interestingly, the markets were okay with the virus as long as it was contained ‘over there,’ but when it hit Europe? Brother watch out below.
So, what to do when you sell stocks? Well, you can put it in cash or buy bonds. Some folks and funds did the later, driving prices up and yields down in the process. Every down day in stocks was a good day in bonds, but it was still sort of orderly until yesterday and today. I have been doing this line of work for a long time, and a 0.75% (75 bps) drop in the 10-Year Treasury and a 0.50% (50 bps) dip in the long-bond over two trading days is nothing short of spectacular.
As crazy as it sounds, and believe it or not, stocks were actually positive for the month through yesterday, having rallied like crazy on both Monday and Wednesday. What’s more, the economic data released this week has also been pretty good, with both ISM reports above 50 (the yardstick for economic expansion) and a robust Employment Situation report for February. It seems the US economy created a net 273K new jobs last month, the Unemployment Rate fell to 3.5%, and wages rose 0.3%. Shucks, the Fed even gave us a surprise 50 bps rate cut on AND Joe Biden cleaned up on Super Tuesday.
In no uncertain terms, this should have been a great week for the US stock market…should have been. The fear of the unknown and the economics of hysteria conspired to drive down stock prices on Thursday and Friday, and, perhaps more importantly, credit default swaps mushroomed, as the credit market got walloped on Friday and liquidity dried up. In essence, feared prevailed at the end of the week.
Bond yields reflect this, and currently suggest there won’t be any growth in the US economy moving forward, for all intents and purposes. I am having trouble with this. As long as the banking system remains solvent, it is hard for me to envision a true Doomsday scenario for the US economy. Of course, COVID-19 could turn into something worse than the Black Death, but I haven’t read any medical experts suggesting anything near as such.
As a result, yeah, you can call me a little surprised by the magnitude of the fear the last two days of this week; note the key word magnitude. So much so, our investment committee will reconvene next week to determine whether there are some relatively easy ways to ‘sell this massive rally’ in the US Treasury market…and determine whether our clients (and/or which ones) would like for us to do this.
Hey, we aren’t necessarily market timers and we don’t normally get too cute with our allocations; however, when bonds become exciting, well, there has to be some money to be made going the other direction.
Have a great weekend.
Please note: this note should not be construed as an offer to provide investment services, an investment recommendation, or a solicitation to buy/sell investment securities. Market conditions can and do change, and this commentary represents the author’s opinion at the time of its writing and are subject to change.