March 9, 2020
On Sunday, Saudi Arabia reversed course out of frustrations with Russia to agree upon oil production cuts. They came out Sunday and announced that they would increase production and flood the markets with oil. After falling 10% on Friday, crude oil is down an additional 23% to $32/barrel. The combination of lower oil prices and quickly rising virus concerns pushed stock futures to their limits. S&P futures have been down 5% (CME limit) for most of the night. Global markets are also down in similar fashion. Bond yields fell sharply as it appears inevitable the Fed will take action to calm global markets. The 30-year bond yield fell 35 bps to 0.86% and the 10-year note now sits at 0.43%. Fed Funds are pricing in a cut to 0.25% by the end of March and to the zero bound by June. We would not be surprised to see another emergency Fed action as early as this morning.
The BLS Employment report was stronger than expected at 273k, almost 100k more than consensus. The prior month was revised up by 50k. We caution once again, this number is not factoring in the impact of the virus.
As to be expected, inflation expectations are falling rapidly with Treasury yields. As of Friday, the 10-year breakeven inflation rate sits at 1.31%, down from 1.80% at the start of the year. This level is no doubt of concern to the Fed, which has been begging for more inflation for the last nine months.
As we consider the Fed’s options and, in particular, whether or not they will initiate more QE, plummeting Treasury yields enter into that equation. If the Fed were to buy Treasury bonds, it could add to the downward pressure on yields and make matters worse. The Fed could also buy mortgages, but again, as we discussed last Friday, such an action would translate into a run on longer maturity Treasury securities. Might the Fed try to buy some other asset class, perhaps stocks? Currently, they are not allowed to, but we have little doubt that if the market problems become grave enough Congress might grant them “emergency powers” that supersede the Federal Reserve Act. The wild card is the upcoming election and the Democrat’s willingness to help the President.
Boston Fed President Eric Rosengren was on the news wires yesterday and stated the following: “(The Fed) should consider widening the type of assets the Fed can buy.”
On Thursday we ran a poll on Twitter and 76% responded yes to “Does the Fed introduce QE 5 this month? Reminder- QE4 with Bills is already occurring” We bet that number would be close to 100% today.
An important note on credit ratings:
“What (credit) ratings describe isn’t the borrower’s ability to repay principal, but its ability to make interest payments and refinance principal.”– Howard Marks 7/2011
The ability to refinance principal, also known as rolling over debt, is dependent on two factors: interest rates and credit availability. When credit markets freeze up, interest rates rise, and liquidity in the credit markets declines. Under those conditions, companies have a hard time refinancing principal and while the respective companies expected financial situation might not change their credit rating might. Given that over 50% of corporate debt is perched at BBB, one downgrade from a junk bond rating, credit rating criteria are now more critical in the light of current market conditions than at any other time. For more on the situation in the corporate credit markets, we link our article The Corporate Maginot Line.
The quote above finishes as follows: “So ultimately the security of capital providers stems not from the borrower, but from the continued willingness of other capital providers to roll debts in the future.”
The TED spread (Eurodollars less Treasury yields) is a measure of perceived credit risk in the credit markets. As shown below, the spread has recently gapped higher. While still at a relatively low level, a further widening of the spread could prove ugly for corporate bond issuers and investors and problematic for the stock market.