U.S. Economy: The Fed Steps Up

Mid Week Bond Update

U.S. Economy: The Fed Steps Up

The FOMC's extraordinary emergency measures have rippled through the global economy.


The Fed’s 100-basis point emergency rate cut on March 16, combined with its $700 billion bond-buying program, was a big move by any measure. Western Asset’s John Bellows observed that the dramatic actions made it clear that it would any and all tools at its disposal – aggressively, if need be – to attempt to counter the economic fallout from COVID-19.

So far, that includes the FOMC’s offer to buy over $5 trillion in the repo market over the next month and the March 17 establishment of a funding facility for commercial paper to support the flow of credit to households and businesses. That second move was intended to provide a backstop to lenders who would otherwise be unwilling to extend credit to businesses and households starved of cash as commercial activity dries up and household income takes a beating.
 

Central bank rates for the Fed, ECB, Bank of Japan, Bank of England

Chart inspired by Western Asset. Source: Bloomberg, as of March 17, 2020. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

It’s clear that the Fed is taking the approach described by Brandywine Global’s Francis Scotland as “whatever it takes”, echoing the ECB’s Mario Draghi comment during the European financial crisis of 2012. With the U.S. Congress in the process of delivering a trillion-dollar fiscal aid package in the coming days, U.S. financial health could improve well ahead of the physical health of its people.
 

On the rise: German yields

On March 12, German Chancellor Angela Merkel and her ruling coalition broke with its long-standing commitment to a balanced budget in the face of mounting economic damage. The “exceptional circumstance” of the COVID-19 crisis could merit an override the constitutional limits on borrowing. That, in turn, could allow Germany to participate in a European Central Bank-sponsored stimulus package now under consideration, as well as make possible increases in domestic spending to blunt the impact of the virus.

Bunds reacted to the prospect of deficit spending with an increase in yield of some 42.4 basis points (bps) from its intra-day low on March 12, to as high as -0.3796% during trading on March 17. While the rise is noteworthy, the yield remained negative, as it has been since early May of last year – and still well below its 5-year high of 0.98% of June 10, 2015.
 

On the slide: Crude-related EM currencies

Since the breakout of the crude-oil price war on the weekend of March 6-9, the Mexican peso and Russian ruble have set records the hard way, falling more than most EM currencies, down -11.9% and -9.1% respectively against the U.S. dollar.[1]  That’s minor compared to Brent crude, which fell about 36% in dollar terms during the same interval. As of close of trading on March 17, Brent crude traded at $29.09, while West Texas Intermediate (WTI) hit $27.05. For comparison, Brent traded as low as $27.88 on January 20, 2016, at the depths of the previous price/quantity war. WTI reached a low of $26.21 on February 20, 2016.

The coming months will tell if U.S. domestic producers will fare better this year than in 2016. As of March 17, Bloomberg Barclays High Yield (HY) Energy average spread was 1,996 bps, vs. the HY ex-energy spread of 738 bps. In 2016, the equivalent figures for early 2016 were 1,778 bps and 839 bps respectively.

 

Note: The year for all dates is 2020 unless otherwise indicated.

All prices: Source: Bloomberg, March 17, 2020 unless otherwise indicated.


Footnote:

1 Source: Bloomberg, March 6 – 17, 2020

 

Definitions:

One basis point (bps) equals one one-hundredth of one percentage point.

COVID-19 is the World Health Organization's official designation of the current coronavirus disease.

An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options.

The Fed Funds Target Rate - Lower Bound, ECB Deposit Facility Announcement Rate, Bank Of Japan Policy Rate Balance Rate, Bank of England Official Bank Rate are the main policy rates of the U.S. Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England, the central banks of their respective countries.

Bloomberg Barclays indexes:  High Yield Energy, US High Yield ex Energy  are used as the basis for the OAS of their respective named sectors: Bloomberg Barclays High Yield Energy Average Index, Bloomberg Barclays US High Yield ex Energy Average iIndex. These two indices measure the characteristics of high yield bonds of companies in the energy sector, and of all  high yield bonds of companies *not* in the energy sector.

A spread is the difference in yield between two different types of fixed income securities with similar maturities but for different credit sectors.

The repo market refers to the market for short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.

The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System (Fed), responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Brent crude oil is a major trading classification of sweet light crude oil that serves as a major benchmark price for purchases of oil worldwide. 

West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. 

Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

High yield bonds, also called junk bonds, are bonds with below investment-grade ratings (BB, B, CCC for example) and are considered low credit quality and have a higher risk of default.

The Russian ruble is the national currency of the Russian Federation; the Mexican peso is the national currency of Mexico.

Commercial paper is a commonly used type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities.

The European Central Bank (ECB) is the central bank of the 19 countries using the euro as their national currency.

Bunds” refers to bonds issued by Germany's federal government. Bunds are available in 10- and 30-year maturities.

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