Why the bond market looks so worried about the coronavirus outbreak
Falling bond yields are reflecting investor fears about the rapidly spreading coronavirus, yet stocks are rallying near their highs, even as the virus has now infected more than 40,000 people.
The two markets appear to be diverging as low bond yields flash a warning of potential economic weakness ahead, and stocks seem to have heard an all-clear about the virus, which has now killed 910 people, nearly all in China. The common denominator moving both markets is the prospect of central bank easing.
“It’s basically a stimulus trade,” said John Briggs, head of strategy at NatWest Markets. “It’s either an expected or delivered stimulus out of China, if they support markets, and there’s the potential that they could do more if the economy slows. In the U.S., there’s the assumption if things get bad, Powell is on your side.”
China’s central bank has injected billions in liquidity, loosened lending restrictions, pared rates in its repurchase, or repo operations, and is expected to cut its loan prime rate.
Traders are also betting the Fed will act if need be. The futures market is now pricing in more than one Fed rate cut for this year, even though the central bank is not forecasting any and has said it is on hold. On Friday, the Fed released its semiannual report to Congress ahead of Fed Chairman Jerome Powell’s testimony on Tuesday and Wednesday. In that report, it said the coronavirus is a new risk to the outlook.
The Fed is also currently buying $60 billion in Treasury bills each month, to expand its balance sheet, as a backstop for the repo market.
Briggs said the idea that the Fed will ease more if the economy turns down or financial conditions worsen, is helping to elevate stocks, while bond yields are moving lower on the same view that rates will stay low. U.S. yields are also moving lower as Treasurys draw in buying from pensions and global investors who view U.S. Treasurys more attractive than other negative yielding sovereigns.
“The history of these things shows that three months down the road, the market’s higher than where it started,” said Art Hogan, chief market strategist at National Securities. “We know there’s going to be economic damage — some permanent, some of it temporary. … At the same time, it’s the rapid response and liquidity from the People’s Bank of China and the healthcare response, quarantining 75% of the country. They’re steps in the right direction.”
Economists in the last several days have raised the flag on global growth concerns, because the virus continues to disrupt travel and manufacturing, and millions remain locked down in Chinese cities. Treasury yields were lower Monday, and the 10-year has sunk to 1.54% from 1.83% on Jan. 17, right before U.S. markets began trading on the virus. Yields move opposite price.
Stocks, meanwhile, sold off about 3.5% as China locked down cities and travelers were restricted, but the market has since rebounded. The S&P 500, at about 3,337, is now about a quarter percentage point, or 8 points, above its Jan. 17 level. The S&P is about 10 points below its all-time high. The Nasdaq, however, is now at an all-time high.
Stocks have surged as investors brush off the virus as being a temporary problem for the economy because those same forecasts show a bounce back in the second quarter.
“I think the point is until you get certainty, or this passes or we have some sort of ability to estimate the actual impact, you’re going to keep more of the Fed priced in than not,” said Briggs.
There are some things that could change the stock market’s response.
“Investors should brace for a slew of profit warnings over the coming weeks from companies with significant operations in China. The near-term economic data is also likely to disappoint,” noted BCA analysts.
The stock market could also react if the Fed sounds hawkish, or if bond markets go very low, reflecting even more fear. Briggs said there’s a chance the 10-year yield could make it to 1.40% and its new range has moved lower to 1.50% to 1.80% from 1.65% to 1.95%.
James Camp, managing director of strategic income at Eagle Asset Management, said he thinks the 10-year will hold 1.50%.
“I do think it’s the line in the sand, and I do think if it goes below 1.50% there are problems that are bigger than the virus,” said Camp.
Camp said he doesn’t see the stock and bond market at odds with each other. “I think they’re both right. I think it’s going to be a show-me year for companies.” He also said there’s plenty of demand for Treasurys, but the yield on the S&P 500, based on corporate dividends, would be 1.8%, more attractive than the lower 10-year yield.
The Fed is not going to rush to act either.
“Obviously, they have expanded their balance sheet … I think the 2019 cuts were reluctant. They had the fourth quarter 2018 policy mistake of raising rates. I don’t think the Fed is going to move rates lower here. We’re all operating within a reasonable assumption there’s an endgame to this thing in the next couple of weeks,” he said.
Camp said, if it drags on and hits the economy, the Fed will consider acting.
“It’s the what we don’t know,” said Hogan. “Does 40,000 go to 80,000 or does it peak at 50,000. The People’s Bank of China is going to pump liquidity every day … The street and the Fed are not in the same place, in terms of cuts right now. The street has two and the Fed has zero.”
UBS economists were among those that trimmed their first quarter GDP outlook, shaving 0.2 percentage points this weekend.
“We see the net effect on the US as being small, but the quarterly swings are likely to be measurable. For the US, we see the effect coming through three channels: tourism, exports, and a temporary disruption to manufacturing because of delayed imports ” the UBS economists noted.
Nomura economists said they were shaving 0.2 percentage points, on top of a previous 0.2 percentage points from the first quarter because of the virus. They now see first quarter U.S. GDP growth at 1.1%, down from the fourth quarter’s 2.1%, before rebounding to 1.6% in the second quarter.