With the economy stalling out over the past six weeks, the U.S. Treasury market appears to have had an appropriate response to the direction of monetary policy, risk and uncertainties regarding fiscal stimulus, and foreign and domestic demand for Treasury bonds.
It would appear that investors are preparing for the average inflation targeting regime, a quicker and more brisk pace of asset purchases or perhaps a yield curve cap out to the three-year maturity spectrum.
Domestic and foreign demand for Treasuries
Domestic demand remains adequately improved. Foreign demand has dropped off in recent months, which might be attributable to the drop of international commerce and home bias during the economic shutdown and possibly to the lack of confidence in the U.S. response to the pandemic.
Inflation expectations, the term premium and Treasury yields
Inflation expectations continue to diminish to unhealthy levels below the Fed’s 2% target. The market continues to price in threats to economic growth and the risk of deflation, which pushed the term premium built into bond yields below zero during the early phases of the trade war.
The Fed does need to be attentive to protecting price stability and inflation expectations along the zero boundary. Should the Fed move toward the adoption of an average inflation targeting regime, this set of data will be critical toward stable inflation expectations.
The impact of the coronavirus on other asset markets
The trade war and the coronavirus sent an already shaky economy into outright recession, which will have a long-lasting impact on the ability of state and local governments to finance their debt.
Because local government cannot simply declare bankruptcy and must continue to support basic services and health care facilities during the pandemic, the bond market has priced in the increased risk of default for municipal bonds. As such, the municipal bond spread climbed to 2008-09 financial crisis levels, but has since receded, though remaining higher than normal.
The disconnect between the economy and the stock market becomes apparent when you realize it’s the only game in town. With interest rates approaching the zero bound, the only decent return available for investors has been in equities.
Interest rates and the real economy
The decline in Treasury yields has followed the path of the U.S. trade war and its impact on the real economy. As the figure below illustrates, manufacturing and trade sales have been in decline during the global manufacturing recession for which U.S. tariffs were the catalyst, spreading from China to Germany to Italy and the U.K. and all other industrial centers in between.
What’s most disheartening is that new manufacturing orders have also suffered, which is not-so-good news for the economic recovery that we hoped would materialize before the onset of the coronavirus.
Manufacturing conditions as reported by the ISM survey have been closely correlated with 10-year yields over the past decade, though one would doubt a resurgence in bond yields given the current state of monetary policy.
Real (inflation-adjusted) interest rates and the real economy
Interest rates and inflation have both been squashed out of existence by a combination of factors ranging from the efficacy of central bank policies, to the disruption of global supply chains, to the moderation of economic growth in the developed economies of the world.
The result has been a diminishment of the equilibrium real rate of interest and real (inflation-adjusted) interest rates shown in the first figure below. The second figure shows the impact of the moderation of U.S. economic growth on U.S. real 10-year yields.
Fed’s response to economic downturns
Investors have clearly been conditioned by the central bank to expect it to take appropriate action in response to domestic and global economic and financial events.
The Fed’s track record over the past 35 years has been robust and impressive. We do not see the Fed backing off its strong and sustained actions that it initiated during the pandemic.
Should there be a second wave next winter, we would anticipate a greater pace of risk taking that results is a more robust set of liquidity commitments by the Fed and the use of such facilities as the Main Street Lending Program to play a critical role in the financial and economic firefighting that will be necessary to combat a second wave of the virus.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
