The turmoil and volatility in the equity markets is also greatly affecting bond markets, with both taxable and tax-free yields shifting down sharply.
You can see the dramatic drop in yields this year, particularly in US Treasury yields, with the very large drop in the past month as the coronavirus outbreak has moved almost all other news to the sidelines. It has sent both the 30-year and 10-year US Treasury yields to record low levels, with the 10-year cruising through the past record low of 1.35% set in July of 2016 and the 30-year bond yield blowing through the 1.95% record set in August of 2019 when US Treasury yields gapped down in sympathy with European and Japanese yields. Time and time again, we see the flight into US Treasuries almost regardless of yield.
Whenever there is a crisis, perceived or real, Treasuries are the go-to investment. We see the various dips in yields in the past 25 years: the Thai Bhat currency crisis of 1998, the downdraft following 9/11, the fallout after the Lehman bankruptcy, the drop in confidence following the Greek crisis of 2010, the drop in yields in 2016 following Brexit, and now the coronavirus. In all these cases there were, of course, other supporting factors. The past year was seeing drops in yields as US yields came down in sympathy with foreign yields.
Muni yields also have dropped – not nearly as much as US Treasuries, but this is a common occurrence when flights to quality happen. Nothing stays up. Credit spreads widen as the move to Treasuries exacerbates.
“One is the Loneliest Number”
Song, Three Dog Night, 1969, lyrics by Harry Nilsson
The Federal Reserve cut the fed funds target rate by 50 basis points on March 3rd, to a 1–1.25% range from a 1.50–1.75% range. The 10-year Treasury bond yield plunged on March 3rd, with the bond moving from 1.17 down to below 1%. It is at 0.96% as we write this piece. The only thing that is a positive is the fact that it is a positive yield. This compares to a 10-year German government bond yield of -0.641, and a 10-year Japanese government bond yield of -0.148. We would expect to see some fiscal stimulus here as well, particularly if the crisis worsens. This stimulus could include moving ahead with an infrastructure program that the administration has NOT pushed so far in this presidential term. And you may see this on the state level as well, particularly since most states are in good fiscal shape from the economy, which has been strong until this crisis.
How to manage this?
From a big-picture standpoint, we saw the negative yields in Europe and Japan go positive as we went into fall 2019. There seemed to be growing recognition that negative rates were effectively “pushing on a string” and that they were not helpful to financial institutions. The Fed’s action on March 3rd is probably not the last one. The dramatic drop in yields occurred AFTER the virus finally showed up in the US. And we don’t know the economic effects yet. We do know there is a large multiplier effect from this pandemic. Think about restaurants and hotels with far fewer patrons. They lay off workers, who then don’t spend money, etc. Sporting events, meetings, rallies, concerts, and other gatherings get cancelled or reduced, and a subsequent multiplier effect drop in economic activity results. On the muni front, we worry about regional hospitals POSSIBLY being overwhelmed. We worry about a drop in economic activity that affects things everything from sales tax receipts to turnpike revenues. Drop in demand is already affecting airports, landing fees, and vendor revenues at airports. Port authorities will see reduced tonnage of shipments. My colleague Patricia Healy has written on this: https://www.cumber.com/cumberland-advisors-market-commentary-covid-19-and-municipal-credit-quality/).From a bond portfolio management standpoint, the US coronavirus outbreak means two things.
First, emphasize quality of holdings. We don’t know the duration of this crisis, but we do know that credit-spread widening is almost always a byproduct of this type of event.
Two, keep a barbell structure; that is, keep both longer and shorter positions – longer to capture some positive yield while we work through the crisis and shorter to take advantage of the eventual rise in yields. When does that happen? We don’t know. But, in our experience, yields that have dropped sharply, as is the case now, usually rebound at some point.
This graph captures the 10-year US Treasury yield and the trailing 12-month CORE CPI for the past 20 years. Prior to 2000 we had some incidences of this – mostly around 1979 when inflation was booming and the bond markets were disbelievers, and then during the stagflation of 1974–1975. We have seen this phenomenon for the third time in nine years now. In general, the duration of these periods is a year to a year and a half. The situation reverses in one of three ways – either a rise in yields or a rollover in inflation or a combination of both. CORE inflation recently hit 2.5%. Certainly, inflation will slow down if the economy backtracks. But if the virus crisis is short-lived, the economy should be able to get back on track. Going into the COVID-19 crisis, the economy was in very good shape, with 3.5% unemployment, still-low inflation, and real GDP growth in 2019 of well over 2% (nominal 4%).
We hope and pray for all during this time. But, speaking from a bond portfolio standpoint, we note that defensiveness is called for.
Fixed Income Research Assistant
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