What's Next For Financial Markets?

History is being made in the financial markets. Every week seems to come with the setting of a new record: the quickest equity market drawdown ever, the highest stock volatility since the depression, etc. On top of that, we have seen Congress and the Federal Reserve enter uncharted territory with the breadth and depth of new programs to save the country from economic ruin. The U.S. is not alone in this effort; it is happening around the globe.

Winston Churchill once said: "Everyone can recognize history when it happens. Everyone can recognize history after is has happened; but only the wise man knows at the moment what is vital and permanent, what is lasting and memorable." We can probably agree that the actions that the Fed has taken in the last few weeks has been vital and memorable, yet it is too early to determine if they will be permanent and lasting.

Remember this tweet from President Trump?

I think this question has been answered. The government, especially Jay Powell, deserves an A+ for its response to the financial crisis. It’s too early to assign a grade for the administration's handling of the health crisis…but it probably won’t be nearly as high when history is written.

Let's start with a review of some major events last week.

Global Stocks Rally

US stocks logged their best weekly performance since 1974 with the S&P rocketing up by more than 12%. International equities also staged a terrific rebound, particularly the ones that had suffered the worst YTD drawdowns. Greek, Brazilian and German markets were among the biggest gainers on the week, yet remain depressed in terms of YTD performance. Sentiment appears to have shifted, coinciding with indications of the “flattening of the curve” of COVID-19 infections. The narrative surrounding the reopening of the economy turning to “when and how” has given hope to investors. The S&P 500 is now 25% off the recent lows and down just 13.6% on the year.

Equities Move Higher on Lighter Volume

The move higher in stocks last week was clearly impressive, but the jump took place on declining volumes. SPY volumes are half of the level of mid-March, with the 5-day moving average of shares traded falling to 171 million shares. Granted, the shift back into stocks is bound to take place at a slower pace than when investors were in panic liquidation mode. Volumes are still 2-3 times greater than prior to the crisis. Overall NYSE single stock volume is also lower but still elevated compared to earlier in the year.

Implied Volatility Tracks Lower

It is difficult for volatility to sustain the panic levels witnessed last month. Even though we are still getting large daily swings in the equity and credit markets, the options market is anticipating a continued path to normalcy. One-month implied volatility on SPY has dropped to 39% from a peak of 80%. Volatility on investment-grade corporate bonds (LQD) has fallen the most, declining to 15% from a high of 70%, and has even dipped back below long-dated UST vol (TLT). Fed support and intervention may have reduced the “tail” in fixed-income markets, but won’t protect investors from fundamental deterioration in the event the economy fails to emerge as expected from the nationwide lockdown.

Stock Bid/Ask Spreads Decline 

Bid/ask spreads for individual stocks in the S&P 500 are declining, mirroring the drop in realized volatility. The median bid/ask spread peaked a couple of weeks ago at 24 bps, but has since fallen to approximately 10 bps. Remote trading floors may prevent bid/ask spreads from falling back to pre-crisis levels, however, tighter markets can be expected if volatility continues to subside. 

Fed Intervenes in Muni Market

The municipal bond market received Fed support last week. A Municipal Liquidity Facility will offer as much as $500 billion in lending to states and municipalities, by directly purchasing that amount of short-term notes from states as well as large counties and cities. The Fed will “continue to closely monitor conditions in the primary and secondary markets,” which indicates additional support could come if municipal issuers can not access the capital markets. 10-year Muni/UST ratios are still elevated at 174%, and the yield of the Barclays HY municipal index has not recovered to the same extent as other segments of the credit market.

IG Bond Fund Flow Turns Positive

For the first time in many weeks, high-grade bond funds experienced a net inflow. YTD, the loan funds have suffered the worst outflows, shrinking by almost 11% in total AUM. Not surprisingly, money market funds have received massive inflows as investors seek safety from the wild swings in most other markets. Money funds have seen their AUM grow 21% YTD. The growth in money market AUM should help offset the increase in T-Bill supply resulting from the government fiscal stimulus measures. 

Yield for High-Grade Short Paper Drops

Part of the $2.3 trillion program announced by the Fed on Thursday is targeted toward stabilizing the asset-backed securities (ABS) market and structured credit such as CMBS and CLOs. The Fed has cut short rates to zero, and it wants to get yields for borrowers lower for the transmission mechanism to work properly. The 3-month CP/T-Bill spread is now less than half of its peak yet has not fully normalized, and the secondary market spread for AAA-rated ABS such as credit cards, auto loans and student loans is also half its peak, but needs to more fully retrace for new issuance of loans to be at rates that will be viewed as stimulative to the economy. 

Support for “Fallen Angels”

Not to be left out of the party, the high yield market got its own Fed program as well. The Fed announced plans to purchase up to $850 billion of fallen angels (companies downgraded from IG to no lower than BB-) as well as HY ETFs. Only credits downgraded after March 22 are eligible, which will include companies like Macy’s and Ford. Citigroup estimates that $200-$300 billion of debt could get downgraded in 2020 alone. With its support for the high yield market, along with the other programs now in place, the Fed has extended support to virtually every segment of the fixed income market. The spread between BBB and BB bonds has fallen from a recent high of 450 bps to 283 bps today.

High-Yield Market Gets a Bailout

High yield ETFs exploded higher after the announcement of Fed support. HYG had it’s largest single-day gain of 6.6% to close at a 5-week high and a 4.6% premium to NAV. The Fed can buy a maximum of 20% of any single ETF’s shares. HYG volume was 87.5 million shares on Thursday, five times the 50-day average volume of 16 million shares. Government assistance programs are now in place for small, medium and large corporate credits across the rating stack. Compared to 2008 and 2009, the reaction function from the official sector has been much deeper and broader.

No Fed Program for Commodities

With the exception of precious metals, it has been a pretty horrible year so far for the commodity markets. Gold rallied last week to close at $1,685/ounce, not far from the 2020 high of $1,703. Precious metals appear to be benefiting from inflows from investors worried about the long term consequences of record fiscal deficits and the acceleration in the growth of the Fed’s balance sheet. The two hardest-hit segments of the commodity market are energy and industrial metals - both of which are grappling with the rapid drop in global demand. In addition, most individual commodity curves are significantly upward-sloping, making direct investments via futures expensive to buy and roll.  

Conclusion

There is little doubt that the official sector response to the economic arm of the crisis has been both quick and powerful. Through the various fiscal and monetary programs, order has returned financial markets. Even with such tremendous support, it is easier to call the next 10% move in the stock market:

1. We still do not have any clarity on the impact of corporate earnings.
2. Stimulus checks and unemployment benefits are yet to make their way into the hands of the people who need them most.
3. Financial markets and the psyche of the American population is not prepared for a national lockdown that goes beyond early May.

Tail risk and downside risk are not the same things. The tail risk may have been reduced thanks to the actions of the Fed and Congress, but the downside risk has not. Excessive economic optimism in the bond and stock markets appears to have replaced extreme fear in just a matter of weeks. We need to remember that the Fed is trying to control liquidity, not value.