At the moment, the Federal Reserve (Fed) is fighting a potentially losing battle – the bond market.

  • After cutting rates to zero and launching Quantitative Easing (QE) of $700 billion – the markets crashed.
  • The European Central Bank (ECB) starts an $800 billion QE program, and the markets fail to move.
  • The Fed injected liquidity into money markets, the credit market, and is buying municipal bonds.
  • And the market crashed more.

Bonds

Nowhere to Hide – Bonds

The typical asset allocation, buy and hold strategy is showing its weakness right now.  Retirees using this strategy are taking massive losses and are being told to “hang in there” by the “other guys”. Their stock strategy has hurt millions of retirees.  But I want to talk today about Bonds.

In the asset allocation strategy the “other guys” use, there is usually a 60% – 40% blend.  60% goes to stocks and 40% to Bonds.  We are now in an EXTREMELY low interest rate environment which creates two problems for retirees:

  •  Your not getting much of a return at all on your bonds and bond funds with interest rates this low, and…

most importantly…

  • You are taking on a level of interest rate risk that has never been higher in our countries history… and yet, the “other guys” tell you to put your “safe money” in bonds and bond funds at this extremely low interest rate environment.

We may be in an environment, where for the first time in decades, you will open your March statement and see large losses in Stocks, Bonds and Precious Metals.  Precious Metals is a discussion for another day.  I want to focus on Bonds here.

Why would bonds lose money?

Bonds lose money for three reasons:

  • Interest rates rise
  • Too much supply and not enough demand
  • Eroding confidence in the bond’s ability to pay back interest

We have all three in spades right now and I saw this for the first time yesterday as I went through the principal guaranteed options.  I noticed that the 10-year CD was at about 1.4%, the 10-year Treasury was at 0.97%, and the AAA Corporate was at 1.5%.  That is normal.  Here is what was NOT normal.  The 10-year AAA Muni yield jumped to 2.4% and the 10-year BBB yield jumped to … 11.7%!!

Here is what that means.  Investors’ confidence in the Municipal market is eroding since the Municipal markets are tied into the state’s train wreck financial mess.  But the BBB rate at 11% signals investors expectation that most of the High Yield debt will default.  I hope you take note of this “canary in the coal mine”.  High Yield bond prices are telling you that there are going to be major problems with High Yield bonds.

What about 10 year Treasuries?

10-year Treasury yields have jumped from 0.97%…. yesterday… to 1.13% today.  No big deal, right?  No.  That’s is a loss of 14% in a day.

The realization that the current pandemic will result in a massive spending boost by governments around the world has spooked bond investors. A wave of new sovereign debt will be hitting the markets shortly. Despite the extreme risk aversion and a historic repricing in stocks and credit, government bond yields are climbing. There is nowhere for investors to hide.  This sharp selloff in both bonds and stocks is highly unusual.

Who is selling bonds?  See below.  Looks like everyone is selling!

High Yield Corporate Bond prices

 

 

Investment Grade Corporate Bonds

 

 

High Yield Muni Bond Prices

 

 

Total Bond Prices

 

 

Market Volatility

 

Huge volatility continues.  Here is some perspective:

 

 

VIX – Volatility Index

 

Today, we’re seeing the highest VIX reading in history. Take a look.

 

 

This selloff has been the sharpest in history.

 

 

The S&P 500 has swung 4% or more in either direction for the last seven consecutive sessions, topping the previous record of six days from November 1929.

Everyone has been slashing their GDP forecasts but this from Deutsche Bank is the worst I’ve seen. Yet I have a hard time disputing it. We have never seen a shock this hard happen so fast.

Key Points:

  • Deutsche Bank’s global economics team forecasts US GDP to drop 13% (annualized) in this year’s second quarter.
  • This would be the worst quarterly contraction since World War II.
  • DB believes this “truly unprecedented shock” will continue for some time as the virus spreads further.
  • On the plus side, DB also expects a 5% GDP rebound in the second half, leaving the full year at a -1% change.
  • Remember this is a worldwide problem. Economies that are weaker than the US will see even greater contraction.

This is a crazy number but it may seem less so after we see tomorrow’s weekly jobless claims data, which all signs say will be brutal.  GDP can’t grow without consumer spending and consumers can’t spend unless they have income. The bigger question: what kind of fiscal stimulus Washington will pass, and how much it helps?

 

The Fed

 

The Fed is reopening its most controversial and despised crisis-era bailout facility, the Primary Dealer Credit Facility (PDFC). The facility’s real purpose is to transfer the toxic bonds and securities from failing financial institutions and corporations (through an intermediary) onto the Fed’s balance sheet.

The objective of this sleight of hand is to recapitalize big investors who, through their own bad bets, are now either underwater or in deep trouble. Just like 2008, the Fed is now doing everything in its power to save its friends and mop up the ocean of red ink that was generated during the 10-year orgy of speculation that has ended in crashing markets and a wave of deflation. Check out this excerpt from an article at Wall Street on Parade. Here’s an excerpt:

“Veterans on Wall Street think of the PDCF as the cash-for-trash facility, where Wall Street’s toxic waste from a decade of irresponsible trading and lending, will be purged from the balance sheets of the Wall Street firms and handed over to the balance sheet of the Federal Reserve – just as it was during the last financial crisis on Wall Street.”

Look at the SIZE of the Fed rate cut that was ignored by the markets!

 

 

The S&P 500 responded well to previous Fed QE programs…but not this one.  We knew this day would come.  We told you this day would come!

 

 

Defaults are coming.

 

 

Margin Debt

 

Margin debt is when investors borrow against their securities and use their securities as collateral. Margin debt is the ‘gasoline,’ which drives markets higher as the leverage provides for the additional purchasing power of assets. However, that ‘leverage’ also works in reverse as it provides the accelerant for larger declines as lenders ‘force’ the sale of assets to cover credit lines without regard to the borrower’s position.

That last sentence is the most important. The issue with margin debt, in particular, is that the unwinding of leverage is NOT at the investor’s discretion. It is at the discretion of the broker-dealers that extended that leverage in the first place. (In other words, if you don’t sell to cover, the broker-dealer will do it for you.) When lenders fear they may not be able to recoup their credit-lines, they force the borrower to either put in more cash or sell assets to cover the debt. The problem is that “margin calls” generally happen all at once as falling asset prices impact all lenders simultaneously.

Margin debt is NOT an issue – until it is.

Given the magnitude of the declines in recent days, and the lack of response to the Federal Reserve’s inputs, it certainly has the feel of a margin debt liquidation process. This was also an observation made by David Rosenberg:

“The fact that Treasuries, munis, and gold are getting hit tells me that everything is for sale right now. One giant margin call where even the safe-havens aren’t safe anymore would trigger the dominoes. Except for cash.”

Unfortunately, FINRA only updates margin debt in arrears, so as of this writing, the latest margin debt stats are for January. What we do know is that due to the market decline, negative free cash balances have likely declined markedly. That’s the good news.

 

 

Coronavirus Update

 

The number of confirmed COVID-19 (coronavirus) cases keeps climbing.  Markets will respond when this levels off and declines.  That is what happened to both China and South Korean markets.  Around a month ago, Singapore ranked second in coronavirus cases for countries behind China.

Today, it’s 26th. The number of cases in Singapore is rising, but only in the low double-digits. Though the threat is far from over, it’s under control.

The number of confirmed global cases of the coronavirus has risen to over 330,000, according to the World Health Organization, and deaths increased to over 13,000.

California just announced that there are 1,000 cases in the state, and they expect 25.5 million within eight weeks. If this is true, it will exceed even Italy’s rate of infection.

The U.S. has over 14,250 cases of the virus and deaths have climbed to over 220.

California’s 40 million residents must stay at home except for essential activities. The lockdown – the largest in the U.S. – began Thursday night.

We are starting to see initial unemployment claims rise.

Italy is hard hit due to its older demographic.

 

 

Major outbreaks appear to be in a narrow temperature range.

 

 

The number of new US coronavirus cases:

 

 

Economic Distancing

 

We need to think about supply chains. The US is running out of something as simple as mouth testing swabs. It seems the entire world supply is made by two companies. When I was asked where I thought those were, I replied “China.” It is worse. They are both in Milan, Italy. Milan is in lockdown. The swabs are on the dock. But they are in their own kind of quarantine.  We need to be smarter with our supply chains.

We can’t fix it all at once, but we should make a start. The Milken Institute has a list of 101 different vaccines and drugs that are in process or are being tested.

 

Social Distancing

 

  • With 11 million people in Wuhan China and 68,000 reported cases, Wuhan’s infection rate was about 0.6%.
  • If this applies elsewhere, your odds of avoiding an infected person are 99.6% if you only come in contact with one other person.
  • The odds drop quickly. Being in contact with 100 people reduces your odds to 54%. At 500 contacts, the odds of avoiding an infected person drop to 4%.
  • Reducing social interaction is the best way to mitigate the spread of the disease and minimize economic disruption.

 

Banks

 

We are watching the banks carefully.  How much exposure do US Banks have to Energy?  Good news below!

 

 

The US banking system is in good shape. Below is the tier-1 capital ratio over time. That’s not to say that some smaller banks won’t run into trouble, especially those exposed to the energy sector.

 

 

European Banks never really recovered from 2008.  European bank shares dropped 11% on Monday alone.  Do you know why?  Because their Central Bank was a heavy buyer of… US Stocks!  Yes,the ECB is a hedge fund!  They took a massive hit when US stocks tanked.

 

 

Market Data

 

  • The Panic Button has been pressed. It’s been years since we’ve had to dust off the Panic Button. The indicator measures various forms of stress in markets, and it just hit a record high.
  • No solace. In many respects, there is no comparison to the unrelenting pressure investors have faced over the past week. On Monday, not a single security on the NYSE managed to tick to a 52-week high at any point during the session.
  • Margin hike. In order to minimize the probability of liquidations, exchanges are hiking margin requirements on futures on an almost daily basis.
  • Worst ever. Monday marked the worst-ever day for the Nasdaq Composite (-12.3%), with history dating back to 1970.
  • Less than 5% of S&P 500 stocks are above their 200-day moving average – the lowest since early 2009.
  • Analysts continue to downgrade S&P 500 earnings estimates.Wiping away years. The Dow Industrials have given back several years’ worth of gains in less than a month. Investors have never really suffered anything like this before. If we once again assume the worst case, then the Dow would have to travel further to wipe out the median number of days’ worth of gains.
  • Safe” haven. Gold is often thought of as a place to park assets when things get out of hand. It hasn’t worked well, and for silver it’s been worse.
  • Fiscal and monetary responses are most like 2008, and price action to 1929
  • There is a common perception that investors won’t step in en masse until the virus losses some of its grip on the public consciousness. Based on news flow during 9/11 and the financial crisis, there may be some credence to that idea.
  • Super stressed. The Panic Button that we looked at on Monday reached a new record on Wednesday.

 

 

All content is the opinion of Brian J. Decker