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At mid-week, COVID-19 continues to spread globally, with new cases reported in the United States, Italy announcing a number of school closures to contain the virus’ spread and General Electric citing potentially large short-term impacts to its cash flow and operating profit. But the global policy response gathered steam today as well with the Bank of Canada cutting rates by 50 basis points. Meanwhile, incoming Governor Bailey at the Bank of England suggested bridge financing may be made available to UK corporates “in the very near future.”

Market volatility continues

Financial markets remain very volatile on a daily and even intraday basis. We do not claim to have any edge or unique ability to forecast the progression of the virus. In addition, leading medical experts have told us that such an exercise is effectively impossible. We do note that one potentially encouraging sign very recently is the relative stability of high yield credit spreads, which have plateaued below 500 basis points. This is important because credit markets can be a useful watch point to gauge the amount of left tail risk that fixed income investors are pricing in on a high frequency basis.

U.S. and global equity markets traded strongly throughout the bulk of today’s New York session. While it’s impossible to precisely disentangle the contribution from every development over the last 24 hours, some investors appear comforted by the surprisingly strong performance of U.S. Democratic presidential candidate Joe Biden on Super Tuesday and what that may imply in terms of possibly less U.S. policy uncertainty. At the time of this writing, political betting markets are implying a roughly 75% probability on Biden winning the nomination, a massive change from just a few days ago.

Rate outlook

We’ve received a number of client questions this week about our outlook for interest rates. And good timing, of course, with the 10-year U.S. Treasury yield briefly breaking below 1% for the first time ever yesterday. The bottom line here is that even at these very low yield levels, we still think government bonds have an important diversifying role to play in multi-asset portfolios. Below is a brief summary of how we currently assess tactical U.S. Treasury exposure through our cycle, valuation and sentiment (CVS) framework. In this context a directional negative view indicates a negative expectation on the price (higher yields).

  • Cycle: Neutral

    Central banks do not have an edge on timing of the COVID-19 outbreak. They see the potential downside economic risks from the Chinese experience, and are likely to provide the accommodation and liquidity demanded by market participants, so as not to risk an unwanted tightening of financial conditions and panic.

    Inflationary pressures are muted in the United States and across the developed markets, which makes dovish decisions easier to build consensus around as well. We’ve received some specific questions around the possibility of negative rates in the U.S. We think the likelihood of this occurring is low. Chair Powell has downplayed the idea repeatedly in recent months. Basically, the Fed appears happy to follow the playbook from the GFC as needed—overnight interest rates at zero, forward guidance and large-scale asset purchases. Relative to their counterparts in Europe, the Fed appears much more concerned about the costs of negative rates, including bank profitability and disruptions to the functioning of money markets.

  • Valuation: Expensive

    10-year Treasury yields are plumbing all-time lows, real interest rates are negative and central banks are trying to inject accommodation. Investors are risk averse and flocking to the safety of government bonds. We would expect 10-year Treasury yields to gravitate back up towards 1.5-2% over the next 12 months, provided risk aversion from the virus fades. But this is a low-conviction view, in terms of both the timing and magnitude of any normalization. In our view, U.S. government bonds are still considerably cheaper than their developed market peers.
  • Sentiment: Neutral

    Price momentum is very strong (a positive). But we are getting mixed signals from fixed income positioning data about whether or not sovereigns have reached a contrarian extreme. Speculative positioning on 10-year Treasury futures remains net short (an implicit bet on higher interest rates) which means that bonds could still rally further on any bad news. In options markets, however, we have seen a sharp pickup in call volumes, indicative of some early signs of euphoria in the government bond market. For now, the evidence on net remains uncompelling and will require further monitoring.

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