Don’t be Lulled by Summer Months

Summer months and markets. Although many markets have gone quiet with volatility continuing to decline, there are plenty of risks to counter trillions in both monetary and fiscal liquidity.

As we balance growing virus cases, an uneven reopening, growing strains with China, schools reopening (or not) and the looming election, we find equities close to their recent highs, Treasury and credit volatility at – or close to the lows and corporate credit spreads approaching levels not seen since before the pandemic.

Volatility (equities, rates, credit)

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It’s not just existing liquidity that’s been winning but the market’s perception of plenty more to come if needed. In many ways, it feels like we have nothing and everything going on right now. We continue to stress that a growing disconnect between markets and economic reality.

Let’s take a look at some charts and key levels

Federal Reserve balance sheet, money zero maturity (Fed’s M3) and gold

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The USD Index back to 2000

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10-year U.S. real yields back to 2000

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Health

The reality of this virus continues to rear its head. We have been cautioning on the dynamics through the summer and into the Fall. And the likelihood of an uneven rebound. We’ve been vocal about market “V” versus economic “V.”

At one point there was a sentiment that warm heat would force the virus away. Yet, even from its early stages the virus was spreading in warmer climates. It’s easy to point to the United States right now, but this virus is still haunting many countries around the globe. Granted, some countries have had better success than others.  

In the end, differences of opinion exist and it’s only natural as we continue to learn each day. The process of school reopening will be extremely uneven, and certainly not one size fits all. And the implementation of another round of shutdowns or threats thereof, is certainly a drag on business confidence. Small businesses across the country have either closed for good or operating on very thin ice. They simply can’t afford to move backwards. Demand at a slower pace far outweighs a change in direction, and even that may not be enough.

This week the president warned that the outbreak is likely to get worse before it gets better cancelling the Republican convention scheduled for August. It was a sobering moment after all of these months. All of this at the same time Congress and the administration work out a plan to salvage the second half of 2020 and likely many jobs that are still at risk.

Markets

Equity markets continue to work through earnings season. It is still challenging to ascertain exactly what these numbers are telling us, with uncertainty on the reopening rising. In many cases right now it’s simply not about valuation: Tesla.

Since June we’ve been advocating a sideways, choppy market off the extreme recovery from the lows on March 23.

See the chart below on the S&P. 

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What we have right now is a massive amount of liquidity in the market. The Fed has not only injected trillions into the system, but assured access to capital in many corners of the market. On the fiscal side, trillions injected directly into the economy with almost certainly more to come.

The challenge right now is timing versus cash liquidity. Bottom line: this virus has been with us longer than most expected. We know very well how quickly cash dries up. Fed’s words: “we can lend, not spend.”

As Congress and the administration go to work, it’s critical a deal from Washington gets done. We are all aware of the fiscal repercussions, but for now the Fed will monetize this debt as we aim to keep this economy afloat. We are not suggesting agreement with that, but this is where things are at in this pandemic. The Fed views this economy as victim to the pandemic, showing a complete willingness to stretch all boundaries. Most of the expansion with the Fed’s balance sheet since March has been through the purchases of both Treasuries and agency mortgage backed securities.

Total outstanding marketable treasury debt vs the Fed’s balance sheet

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On the fiscal side, simply turning off the billions of support each month the government is providing would almost certainly lead to more job losses. Conversely, creating additional incentive for many not to return to work should cease to exist. In listening to small business owners personally, and sorting through the Fed’s most recent Beige book, this behavior is occurring. Mind you, it’s short-sighted to sit home and feel confident of landing a job down the road but this is where things are at in many instances. Behavior is a very difficult thing to predict in normal times, let alone a pandemic. Cash is still a critical component on our way out and we must strike a better balance in this next round of liquidity.

As Robinhood speculators continue to whip around the NASDAQ, our favored measure of concern in the market (US Treasuries), continues to send mixed signals relative to equities. The US rates market led by the long end continues to trade firmly ahead of next week’s Fed meeting and amidst the rising Covid cases and increasing tensions with China. We’ve been hugging the lower end of the rate range for a month.  

Nominal 10-year yields versus the Treasury MOVE index.

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No doubt looking at the chart above, and with volatility at its lows, we are due for a move off these levels. And we are certainly watching the lower end of the range in 10-years which comes in around 55-basis points and was tested overnight.

With growing virus cases, parts of the economy shutting back down and questions around the employment picture, a break through the lower end of the range on the US long end is not be ruled out. Given the lack of long end Treasury supply in this window, coupled with the continued Fed buybacks, we are willing to let this market show its hand right now. But we remain vocal about the Fed’s increasing concern on the economy and open willingness to do more if necessary. 

Lastly, on the corporate credit side, spreads remain very tight and approaching levels prior the pandemic: Certainly the Fed being a very big part of this. Between the commitment to take paper out of the market and its Zero Interest Rate Policy, the quest for quality yield is alive. This coupled with the Fed’s informal forward guidance of being on hold through at least 2022 and wanting employment back to levels from the beginning of 2020. Rates will be on hold for a long time irrespective of formal forward guidance. And as NY Fed Williams indicated recently, the Fed’s informal guidance has been working well.

The Fed

All eyes on Fed meeting this week. Please visit our latest White Paper with thoughts around the Fed’s likely next move to learn more. Timing appears to be the only issue, with meetings this week, September and then right around the November election for context.

Economy

All eyes continue to focus on the fiscal side of the equation with unemployment insurance front and center this month.

Both sides need a deal. In the end, who wants to walk away from the American people in the middle of a pandemic just as cases spike. The President needs the job growth from May and June to continue heading into the fall.

The Democrat’s need to campaign with a spirit of support for the millions that remain victim to a once in a lifetime health crisis: Now state & local workers unfortunately at risk. Stimulus will eventually come after the election but for now we still believe liquidity is needed as the virus lingers longer than expected.

This week’s claims numbers continued to strike a tone of concern with the initial claims now moving higher as parts of the country shut back down. In the end, 32 million Americans are filing some type of unemployment insurance when factoring in pandemic coverage. The job market has a long way to go and so too does this crisis.