US market rates bracing for 1%

Covid-19 is the type of catalyst that both risk assets and core bond markets had been watching for, but from very different perspectives.

1. Bond markets were already trading as if there was trouble ahead (flat curve, rich 5yr valuation and rate cut discount).

2. Equity markets and risk assets generally were motoring ahead, but eyeing the blind spot for a pull-back risk.

The early reaction to Covid-19 had been a tad perverse. The US 10yr fell from 1.8% to 1.6% for starters. But equity markets saw the glass as half full - lower bond yields meant a heightened chance for a rate cut. That, plus a still benign inflation backdrop classically presents a positive underpinning for risk assets.

Fast forward, and there has clearly been a tipping point where vulnerability has been extrapolated. Risk assets have begun to look through bond market spectacles, and are now eyeing risks that are not immediately solvable through simple rate cuts. In turn we expect to see bond yields continue to significantly front run any Fed rate-cut response.

The only logical rationale for an imminent interest rate cut is for the interests of financial market stability e.g. a case where the equity market sell-off turned into an uncontrollable rout. Beyond that, interest rate cuts will neither cure anyone’s flu, nor avert close-down risks for areas that have or will become Covid-19 impacted.

Market rates, in consequence, have and will likely continue to lead any official response from the Federal Reserve. The Fed will be comforted in the fact that policy has already been eased by 75bp (in 2019), and as we turned the year into 2020 the Fed was in the process of balance sheet re-building / liquidity injecting. So no need to panic here, yet.

Before going into predictions for yields, there is one important (non-Covid-19) factor to consider – the excess of demand over supply for fixed income as a theme. Despite heavier USD bond supply, the demand for fixed income has been overwhelming; hence the persistent fall in yields.

The demand side includes some key captive players. These include central banks (QE), private banks (regulatory liquidity buckets) and pension funds (ALM through “near-AAA” discount functions). On top of that players, like insurance companies, that have been forced out the credit curve for yield, have barbelled into core rates too.

And bigger picture impulses are in play too. European (negative) yields remain a drag for US ones, as do the likes of Japanese and Northern European ones generally. The persistent flow of funds into USD has been a coincident outcome from this, which has become a circular process, pushing yields down and USD product up.

These were all in play well before Covid-19 hit.

The Coronavirus backdrop has provided an open door for core bond markets to push through. The 5yr part of the curve has taken the lead, now at 1.15% as we head for the US close; a full 40bp through the effective Fed funds rate. The 30yr at sub-1.8% is just a smidgen above the Fed funds rate ceiling.

As nominal rates have fallen, there has also been a compression versus TIPS yields, resulting in a big falls in implied breakeven inflation - the 10yr B/E is now only a tad above 1.5%. This is a remarkably low market discount for US inflation over the next 10 years, in turn providing fuel for calls for the Fed to step in with some rate cuts.

Calling the Covid-19 spread is a mugs game. But the fear factor that comes from any / every material geographical breakout is now predictable, which points to material slowdown, both direct and indirect. Against this backdrop, there is likely room for yields to test lower from here, even if ultimately morphing into an overshoot to the downside.

The 1% level is a natural target, and we can envisage a scenario where the curve begins to pepper that level in the coming weeks and months, at least along the 2yr to 10yr segment. The 5yr would likely make the break below first, as the 2/5yr segment continues to invert. And the 10yr would not be too far behind as the overall curve maintains a flattening tendency (until the point where the Fed feels the need to cut).

The US 10yr yield, now at an all-time low, does not trade through the Fed funds rate very often. When it has, it has typically been followed by significant Fed funds rate cuts.

The US 2yr has been some 100bp lower than current levels, back when the funds rate was at zero-25bp. At 1.2% it is discounting at least two 25bp cuts.

History also shows that extreme curve flatness (and/or inversion) typically precedes a rate cutting process.

The inversion on the 2/5yr segment has coincided with the 5yr trading rich to the curve. A rich 5yr flags a tendency for lower rates.

Note the maintenance of richness on the 5yr segment even after the Fed had delivered 3*25bp in rate cuts in 2019. This is unusual. Once the Fed has started a rate cutting cycle, the 5yr would typically revert to a cheaper valuation. Instead sustained 5yr richness pointed to an unfinished lower rates process, and that was before Covid-19 hit.