Update on Financial Market Dislocations: What Has Improved & What Has Not?

When you slow down from driving 130 mph for an extended period of time on the highway to a mere 80 mph, it feels like you are going at a crawl. Yet, at 80 mph you still need to pay close attention to everything around you to void potential disaster. That is one way to describe financial markets last week compared to the previous one.

Even though the daily swings in the equity market were not as extreme as they were two weeks ago, the S&P 500 still managed to move more than 10% higher over the last 5-days on what is still considered heavy volume.

The biggest moves, however, may have come in the fixed income markets. Last week, I wrote about the biggest dislocations in the bond market. Today, I can report that the healing process is well underway.

It took an extra few days, but Congress finally passed the CARES Act, which is designed to provide support for individuals and businesses adversely affected by the economic lockdown associated with the spread of COVID-19. 

The legislation includes grants to hard-hit industries, state and local governments, payroll tax relief for companies, loans to small businesses, and direct cash payments to individuals. The relief bill is a massive 10% of GDP, and there will likely be further fiscal stimulus once the full extent of the economic damage is understood.

The policy response globally has been extraordinary

The passage of the bill, combined with promises of support by the Fed toward the municipal and investment-grade bond markets, helped fuel a powerful rally in the credit markets. Let's turn to fixed income markets for an update:

Bond Markets Begin to Heal

With the worst of the outflows and liquidations hopefully out of the way, the fixed-income market is starting to heal. However, the speed of the repair process is dependent on the market. As noted earlier, the Treasury market is still volatile, but functionally intact. The Agency mortgage market is well off its most distressed levels from a week ago, aided by gigantic Fed purchases. Fed intervention in the IG corporate market is yet to be implemented, but anticipation of such activity has helped it rebound. LQD had fallen 20% over the last month, but has since recovered to be down “only” 6.7%.

Markets further away from Fed intervention are slower to recover. Credit-sensitive commercial real estate, for example, is still suffering from illiquidity and distressed prices. CMBX BB spreads are yet to materially benefit from the risk-on sentiment.

Another way to gauge the healing in the US government bond market is through the relative richness/cheapness of off the run securities compared to benchmarks. The Morgan Stanley Relative Opportunity Value Index (MSTVI) tracks the overall dispersion of individual bonds relative to a smoothed spline curve. A high number on the index indicates less market liquidity. As seen below, liquidity levels have improved significantly over the last week, largely due to the Fed's activity in the market.

How About Bond ETFs?

The healing in the bond market can also be viewed by looking at bid/ask spreads of large bond ETFs and movements in “fair value” between ETFs and their net asst value (NAV). When volatility reached its peak, the bid/ask spread of LQD, the largest and most liquid IG corporate bond ETF, increased six-fold from 0.01% to 0.06%. By Friday’s close, it had fallen back to 0.02%.

Similarly, during what may become known as the “Great Liquidation,” LQD traded more than 5% below its NAV. With the Fed set to intervene, LQD reversed course and is now trading at a 1.6% premium to NAV, after closing earlier in the week at a 5% premium. Such large swings are not normal, and when the fluctuations away from NAV get smaller, it will be a very positive signal for the bond market. 

Fixed Income Benefitting From Stabilization in the Funding Markets

Good news alert: the bank funding market is normalizing. Thanks to the litany and scale of Fed programs announced over the last two weeks, the banking system is awash with cash. Three-month T-Bills are trading at OIS-15 bps and three-month Treasury repo is clearing around OIS+15. Even commercial paper spreads have begun to decline, albeit at a spread of 135 bp over OIS. But there is still more work to do before the Fed can relax. Demand for US dollars eased this week with the expansion of the Fed’s currency swap lines to more counterparties. The US dollar retreated from overbought territory and short-dated cross-currency basis swaps collapsed from the extreme levels of the prior week. Good news, indeed.

Negative US T-Bill Rates 

Official Fed policy rates may not be negative, but that has not stopped investors from pushing US Treasury bills into negative territory. One-month bills offer a -0.16% yield, a sign that money markets are flush with cash and investors will pay a premium for liquidity and safety of principal. Three-month Japanese bills yield a similar -0.20%. However, by swapping the Japanese bill back to US dollars by doing a cross-currency basis swap, one can pick up 1.48% in yield compared to a three-month US T-Bill. Some of the dislocations are still present, despite the much-improved funding environment. 

Gold Begins to Shine Again

The huge fiscal and monetary response by governments around the world prompted a rush into non-fiat assets like gold. Gold rallied 8.7% last week, its biggest weekly gain in more than three years. The jump in gold stretched the gold/silver price ratio to a record level of 112. Volatility of the precious metal has also skyrocketed, reaching 50% on March 18th before falling to the current level of 34%. Gold may benefit from global “currency debasement” and “money-printing,” but it may struggle from the fact that despite its safe-haven history, it is still an asset with zero yield, and with real-yields rising around the world, investors have many other choices for potential positive real expected returns.

Equity Put/Call Ratio No Longer Extreme

In another sign of normalization in the markets, both equity option put/call open interest and option put/call volume ratios have moved away from the extreme readings earlier this month. The expiration of S&P index options on March 20th cleaned up the negative gamma profile of option sellers, which should help reduce volatility a little. Profit-taking in long put option positions has helped bring the open interest ratio down to 1.67 from 2.42 at the start of February. Similarly, the volume of puts traded relative to calls has dropped from peak levels. 

Investor Sentiment Hits Rock Bottom

Aside from put/call ratios, there are still plenty of signs that investor sentiment is downright horrible. Bank of America’s sentiment indicator, which includes components such as long-only and hedge fund positioning, credit market technicals, and bond/equity market flows and breadth, is at 0 on a scale from 0 to 10 (0 is extremely bearish, if that is not obvious). The indicator has been at 0 quite a few times before, however. The current uber-bearish stance may help explain the fierce “short-covering” rally over the last few days.

Small-Cap Fundamentals Help Explain Weakness

Last week, I highlighted the recent underperformance of small-cap equities, pointing to the vastly different fundamental characteristics between the smaller companies in the Russell 2000 and the large corporations in the S&P 500. For example, the net debt-to-equity ratio of the Russell 2000 is around 110% compared to approximately 75% for the S&P 500. Variability in the net debt-to-EBITDA ratio is even larger: close to 4x in the Russell 2000 vs. less than 2x in the S&P 500. With earnings for most companies – both big and small – likely to take a hit in the next few quarters, investors appear concerned with the higher leverage/weaker credit profile present in the Russell 2000 small caps.  

Let's Not Forget the Carnage in the Energy Market

Energy markets have dealt with supply shocks for decades. They have also learned to adjust to temporary demand spikes and declines. Now they are dealing with two negative forces simultaneously. Saudi Arabia is pumping more crude than ever to maintain market share within OPEC and US shale producers have been slow to cut back production despite the 65% drop in the price of WTI since early January. Western Canada Select crude prices have been hit even harder, plunging 88% in the last three months. The drop in oil, coupled with the precipitous fall in demand due to the international lockdown, has driven gas futures prices to ultra-low levels. April gas futures touched 40 cents last week.

In summary, the Fed appears to have control over the yield curve. That should ultimately lead to lower volatility of both short and long term interest rates. And once the new programs are implemented for CP, municipal and IG credit, those markets should show signs of additional healing. Markets further away from direct Fed implementation, such as high-yield, non-Agency commercial real estate and structured credit, will take more time. The inevitable turn in the default cycle will also have a greater impact on the more credit-sensitive segments of the bond market.

Stay tuned. The show is not over. (And for the record, I have NEVER driven 130 mph on the highway. That's my story and I'm stickin' with it.)