A trader works on the New York Stock Exchange.
Wang Ying’s photo | Xinhua | Getty
The sharp drop in interest rates this week reflects fear for the future and is also sowing seeds for a recovery once the fear of the coronavirus is gone.
Government bond yields have reached previously unthinkable levels. The 10-year US benchmark briefly fell below 0.7% on Friday, a level more consistent with slow-growing European economies or Japan than with a country that has been one of the most of the global landscape. Bond prices and yields move inversely.
These low yields elsewhere have been a symbol of a decade of futility for indebted European countries and a Japan that is still trying to break its back on deflation. However, that does not necessarily translate into the same fate for the United States.
“When we get out of this in six months, you’re going to have a lot of stimulus in the works,” said Mike Collins, senior portfolio manager at PGIM Fixed Income. “I actually expect a fairly significant recovery in the last six months due to the seasonality of this. Remember, we have had a lot of economic dynamism in this area.”
Indeed, Friday’s employment report was just the latest data point to show that the economy had solid momentum before the coronavirus crisis, but to no avail.
The rush to the market saw the blind sale of securities and huge purchases of government bonds, transactions that seemed to feed each other and that did not respond to the continuing wave of good economic news.
“It has become a kind of circular transaction,” said Kim Rupert, director general of global fixed income analysis at Action Economics. “The stocks are watching the decline over 10 years and the whole curve. It causes the shares to fall and we get a flight to quality. It just ping-pongs between the two markets and makes everything fall.”
But Rupert also thinks that falling yields, while signifying short-term panic, indicate what might be a better way to go.
The debate over declining yields
“Once we get through this, the amount of stimulus in the system could actually be a very good second half positive result,” she said. “Maybe it’s a little counterproductive in the short term, just the whole fear trade hitting lower yields. But at this point, it’s so nebulous that a lot of the effects are difficult to have.”
There is no doubt that lower rates will help cope with a slowdown due to fear of the disease.
Lowering the cost of capital generally helps solve demand-side problems. The Federal Reserve cut its benchmark rate by 50 basis points on Tuesday, which Rupert said was a waste of firepower. “They could have been jawboned,” she said, referring to the ability to simply signal that rate cuts are coming and follow developments before acting.
Instead, the central bank took action, and now the markets expect another 75 basis points from the Federal Open Market Committee meeting this month. The markets however did not seem to be very reassured compared to the decision taken Tuesday, and certain investors fear that the Fed does not have enough political ammunition.
“Panicking because the Fed has run out of interest rate cuts ignores the reality of the past decade, when central banks around the world have been open to unorthodox policy action. It’s probably a bit premature “said Sonal Desai, chief investment officer at Franklin. Templeton fixed income.
Desai is also seeing the economy recover from fear of the coronavirus, even though it believes it will require more than low interest rates.
In addition to historically cheap borrowing levels, she also said that some type of stimulus to help particularly sensitive sectors of the economy, such as the restaurant industry, would also be appropriate.
“At this point, such low rates will be very stimulating,” said Desai. “However, in the meantime, what you really need if you want to stimulate the economy is targeted help to prevent bankruptcy and bankruptcy to a level that the Fed cannot reach.”