Volatility Reemerges

We expected a firm message from the Fed. This has been one of the most extreme times our global economy has seen. Anything short of Powell's message this week would have been a the bigger surprise: There's a long road ahead.

Please find below the Fed's statement and Summery of Economic Projections. 

https://www.federalreserve.gov/newsevents/pressreleases/monetary20200610a.htm

https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20200610.pdf

Powell's message was clear this week: "The Fed is not even thinking about raising rates". The Fed's baseline scenario is "on hold" through 2022. Feels like it will be longer.

This continues to be a very dynamic environment. Short term, risk markets and rates are reversing their most recent move, yet it's important to keep in perspective the direction in both markets of late. Since bottoming on March 23rd, both the credit and equity markets have enjoyed a fairly straight line higher and tighter. And with the economic outlook still very uncertain, the credit markets have assumed a leadership role in short term valuation. The performance of the debt market has been a very big lift for equities. The Fed is aware.

But this longer term chart of NASDAQ lends perspective to the extreme moves in both directions in 2020. It certainly also lends perspective the impact of zero interest rates & balance sheet expansion had from 2009-2018 with little to no growth and a plethora of corporate and sovereign debt added. Easy to see the first signs of trouble normalizing in 2018: Legitimately normalizing.

NASDAQ 2000-2020

In our White Paper from this past Friday, we discussed the notion of additional tools from the Fed. In particular the notion of Yield Curve Control which Powell confirmed this week the Fed has been briefed on. And although they've pared back on asset purchases, clearly the Fed is not backing away from further balance sheet expansion if needed. The marginal impact of additional purchases is questionable, although as the Fed's lending facilities come online their balance sheet will continue to expand.

https://amerivetsecurities.com/the-federal-reserves-red-line/

Markets have come a long way over the past few months. Defying most expectations would be an understatement and volatility should be expected after a move back like this. There is still extreme economic uncertainty, unprecedented jobs picture and risk of a second wave of Coronavirus.

Treasury, Credit and Equity Volatility

The Fed has been clear about not solving it all. Buying Treasuries and mortgages will not solve small and medium business cash flow challenges. It equally will not drive the rehiring of unemployed or furloughed workers. The real way we solve those challenges lies with a continued safe reopening of the economy. Improving financial conditions, in and of itself, is not where this economic shock is at.

In addition to a pickup on volatility across credit and equities, the interest rate markets are equally seeing some violent swings. Why own 10-year Treasuries at 55-basis points if the economy is reopening, the job market showing signs of improvement and the broader gains occurring in higher yielding assets? After all, Treasuries (led by the long end) had their day in the move from January through early March in terms of performance.

In the end, this is what a zero rate policy typically does to assets: forces the need for cash to find more yield and subsequently risk. Many times in ways not supported by fundamentals as we know and have seen before.

But not so fast. The Chairman's sobering assessment of the jobs picture even prior to the impact of Coronavirus was candid. Talking very clearly about the quirks not only with this most recent number in terms of classification but differences between the U6 and U3 rate. This is no typical downturn and likely subsequent recovery.

And despite a continued deluge on both short and long end supply, US 10-year rates found good support around our 95-basis point levels and quickly marched back within it's multi-month range. In the end, performance in risk assets here relative to rates will matter in the weeks ahead. And as the above chart on NASDAQ highlights, the rally in risk was frothy and not very well supported with volumes.

We welcome the pickup in volatility of late. There is simply too much uncertainty regarding the economy, credit valuations and earnings to wind up (and be comfortable) with where the markets had moved to. In October of 2019, investors once again began to push risk markets to all-time highs in early 2020. The purchases of T-bills was seen, in our view, as a green light to drive equity, credit and volatility to extremes. Even Dallas Fed President Kaplan acknowledged the increased risk behavior. It turned out to be a big mistake.

S&P (2019-2020)

The takeaway from Powell this week should be a signal to the markets. There will be a long road ahead over the next few years. And the reasons that rates will remain low matters more than ever. And so will the fiscal side of the equation. And with current valuations, we expect plenty more volatility ahead as the economy reopens, we sort through challenges with Covid and the 2020 election looms.