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A dose of reality

By Henry Adams on 2020-06-12

There has been much by way of talk from the top over the last 48 hours where we have seen releases from the OECD as well as FOMC on the current state of affairs.

The core themes to come from this are that recovery will not be V-shaped with the side-effects of the virus on the global economy being felt for quite some time. For the OECD, the velocity of the recovery is at this stage likely to be most hampered in various Western European countries including the UK, France, Germany and Italy. Aggressive social distancing measures and large stimulus packages come at a cost. There still seems to be a disconnect between this harsh reality and the stock market, although as I type this Thursday evening I find myself constantly decreasing the year-to-date gains. In the US the NASDAQ is up 11% 9.2% 7.36% in 2020, and whilst it does include many winners, does not seem to reconcile with problems ahead, highlighted by Chairman Powell in the US. Rates will have to remain near zero until at least 2022 (or forever) to enable a solid recovery. So with low rates for longer, why does the market appear to have turned in the last session? Stocks have always loved cheap money and additional stimulus. Reality appears to be setting in (at least for a session). Given the destruction of jobs both in the US and globally, there is a very real threat of mass unemployment, that in Powells' words could last "a good few years". Not sure this represents the best selection of vocabulary, but the message is clear and is repeated by the OECD and most nation states.

Given our new addition of the EURO to our product offering, today it makes sense to start our per-currency analysis here. Whilst the idea of debt mutualisation was avoided in the last European Sovereign crisis, being a policy despised by wealthier nations not looking to take on the burden of higher debt piles from the less (wealthy/committed/frugal) southern states, this time around it does appear to be different. A support package that would redistribute to those most needy is being drawn up, surprisingly at the behest of Germany (and France), who had previously opposed such transfers of capital. Further quantitative easing is expected to come, whilst the basket of acceptable debt has already moved into credit (including sub-investment grade paper with the caveat that issuers were investment grade prior to this crisis). It is hard to see how rates moving more negative would help anybody, in particular the banks who are being hailed as part of the solution rather than the problem this time around (more will follow on that, from ourselves and others, later in the year I am sure). Lower rates would hamper balance sheets further as net interest margin becomes something for the history books.

Risk off sentiment can be seen in the UK Government bond market today with both 2 & 3 and 5 (by the end of the day) year Gilts being bought with negative yields and the FTSE closing down 3.99%. We could well be at a crossroads with a realisation that recent exuberance has run out of steam. The Firday UK Treasury bill auction will give us a further glimpse into the sentiment of investors, with a very real possibility of negative prints off the back of growing demand and limited supply coming to market. Yields across 1, 3, and 6 month T-Bills continue to grind towards zero and generally sit in the low single-digits (for the first time we saw secondary inventory offered with negative yields here, although nothing printed, yet). Money market fund returns are not far behind with many in the industry concerned over whether fees will need to be waived or capitulation is the path, but nobody wants to be the first mover into negative territory.

Yesterday the FOMC did not do much to further entertain appetite for, or against, negative rates. Additional guidance was provided though with regard to the FLOOR on monthly purchases in treasuries and MBS, at $120Bn per month. Regarding other tools that are being considered for price stability, the tactics of Australia and Japan earlier in the year were touted as a lever providing more help. Yield curve control, through buying or selling specific bonds at a defined term (most likely to be the 10 year benchmark) is just this tool. In other news, the flood of US Treasury bills, now making up approximately 1/3 of the growing debt pile of $25 trillion is large by any measure - this has pushed returns on the asset class up, with levels in the low to mid-teens available. Risk-off. Yield-on. For now. What next?

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How Jay Powell's Coronavirus Response Is Changing the Fed Forever

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