COVID-19, Extreme Volatility, Fed Emergency Rate Cut

March 12, 2020

Source: Bloomberg Source: Bloomberg

Despite very nice weather over the weekend, the news flow indicated another wild week ahead on Wall Street. Unfortunately, new COVID-19 cases are increasing throughout the world. Northern Italy, which represents 25% of the country’s gross domestic product and is home to 16 million people, was supposed to be quarantined until early April, but now the entire country is impacted. In the U.S., the number of new cases is also growing and New York declared a state of emergency. In the meantime, Saudi Arabia started an oil price war after Russia refused to cut production.

Over the last few years, whenever there has been a potential risk to the economy, the Federal Reserve (Fed) has stepped in and saved the day. This happened in January 2016 and January 2019. All of these Fed actions have reinforced the perception that the Fed is here to help us whenever there is risk. Market volatility has remained very low over the last two years: Why manage risk when we have the most powerful institution in the world to manage risk for us?

While we were enjoying this long period of calm, excess slowly built and complacency grew. The rally in January had signs of blowout capitulation. We saw record trading activities from retail investors, record single stock call options trading and little demand for put options. We also saw drastic price appreciation from “story stocks” such as Tesla and Virgin Galactic.

The last two weeks were a sharp reminder of how volatile the market can be. In two weeks, we gave back all the gains generated since October 2018. The 10-year Treasury rate stands at 0.76% as of Tuesday. The Fed enacted an emergency rate cut of 50 basis points (bps) last Tuesday; however, the market didn’t rally as it has previously, resulting in the credit market’s worst performance in a decade last Friday.

COVID-19’s impact is still unknown and only time will tell. At this point, the fatality rate is uncertain, which is the key driver for its negative economic impact. If we assume the Chinese government knows the most about the virus, the draconian measures taken may indicate that the fatality rate is fairly high.

Buying the dip has been the best strategy in the last few years, but I would be a little more cautious. Last Tuesday’s market reaction to the Fed’s rate cut is worrisome. We have always wondered when monetary policy will lose its potency. Now with the Fed funds rate expected to reach zero by year end and the entire yield curve below 1%, we are dangerously close.

Let’s see if the Fed will do another 50 basis-point cut before or during their FOMC meeting on March 18 and how the market reacts to it. If the risk market cannot rally on further rate cuts or the Fed hints at quantitative easing, the market is at risk of much further downside. The biggest risk for financial asset valuation is that the Fed can no longer influence market valuation.

I have been bearish on the dollar for a while. Now, the dollar is selling off for a different reason: European and Japanese investors are unwinding the carry trade and repatriating the euro and yen back home. If you want to hedge a scenario in which COVID-19 brings the U.S. into recession, buying long euros or yen is a better hedge than going long gold or Treasuries because of valuation. 

Treasuries had a historic rally in the last two weeks and their valuation is very rich and unattractive now. I would use any significant rally of rates to slowly reduce Treasury position. The LIBOR-OIS spread is widening because the market is worried a shutdown of the economy will cause a liquidity crunch among non-financial corporations. When these corporations tap their credit line at the banks, it will drive up the LIBOR rate. When funding becomes challenging, people will sell what they can to raise liquidity, which means gold and Treasuries. 

Key Takeaway

We are deeply aware of the impact the virus is having on a personal level. From a purely investment perspective, the Fed is at risk of losing control of the market, which represents the biggest risk for investors now. COVID-19 has the potential of exposing the credit leverage built over the last several years. Don’t rush to buy the dip, but when you do, buy the security with the best balance sheet. The oil price war probably means a lot of U.S. shale players will default, while the high yield credit market faces challenges.

Tags: Coronavirus | Federal Reserve | Volatility | LIBOR | oil prices | Monetary policy | Treasuries

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