The US economy was very strong during January and February with low inflation, historically low unemployment and slow but steady economic growth. The economic effects of COVID-19 and the extraordinary efforts made to rescue global economies dominated investment markets during March.
Treasury yields plummeted while credit spreads exploded. Markets were volatile and experienced extreme liquidity stress until the Fed intervened. The curve steepened after the Fed took steps to shore up liquidity in funding markets.
In March 2020 COVID-19 was declared a pandemic by the World Health Organization (WHO) which triggered a panic selloff in the equity markets. In the bond markets, the reaction was to sell risk assets, so credit sold off dramatically.
Fixed income played its defensive role as safe haven as the Federal Reserve cut interest rates to zero and announced unlimited quantitative easing and implemented programs from the Financial Crisis of 2007-2008.
The COVID-19 pandemic and social distancing brought certain areas of the global economy to a halt. Fear of a recession expected declines in economic growth and corporate losses escalated.
Congress passed the emergency $2.2 trillion CARES Act, which will provide an extraordinary amount of fiscal stimulus across the U.S. economy. The Fed, US Treasury, and Congress have responded to the market turmoil faster and in greater size than during the Financial Crisis of 2007-2008.
The Fed’s emergency actions and Congress’ outsized fiscal package began to reassure the markets that the government was placing a floor under the markets by supporting the economy.
Federal Reserve Actions
The Fed learned from the Financial Crisis to be aggressive, act early and big to keep the financial markets functioning. The Fed lowered the target rate on March 3 by 50 bps from 1.50% to 1.00%.
On Sunday night, March 15, three days before the scheduled FOMC meeting, it cut the target range by 1% to 0.00% to 0.25%. The reverse repurchase agreement (RRP) rate was set to 0% and the interest on excess reserves (IOER) rate was lowered to 0.10%.
The Fed also re-started quantitative easing (QE), pledging to buy at least $500 billion in Treasuries and $200 billion in mortgage-backed securities over several months.
The Fed began buying $180 billion and realized that it needed to accelerate the purchases. By the quarter-end the Fed announced that it would buy unlimited amounts to stabilize the markets. The Fed bought $820 billion in Treasuries and $290 billion in MBS in two weeks which provided enough liquidity to restore the markets’ functioning. The torrent of money that flowed into Government/Treasury money market funds in March also increased demand for Treasuries.
In mid-March the Fed began offering $1 trillion in overnight repo each day, as well as offering up to $90 billion in two-week repo, $500 billion in one-month repo, and $500 billion in three-month term repos.
Federal Reserve’s Programs
The Federal Reserve can use its balance sheet to support any market that appears in distress and it did so aggressively. Such actions by the Fed and other Central Banks should help stabilize the markets. The Fed acted quickly and decisively to provide liquidity and loan facilities with its ability to be the “Balance Sheet of Last Resort.” The Fed announced at least 8 programs to support bond markets, corporate credit lines, money market funds, and Main Street business lending.
On April 9, 2020 the Federal Reserve announced several new lending programs totaling $2.3 trillion. The new programs include a $600 billion "Main Street" lending program for small-medium sized businesses to support workers on the payroll.
Please refer to the attached chart at the end of this section that summarizes the many programs and highlights of the rescue packages.
Money Market Funds
The selloff in equity markets led to torrential flows, over $625 billion, into money market funds seeking a safe haven. These were the largest inflows seen on record since January 1992. Most of that money flowed into Government/Treasury funds plus $160 billion came from Prime Fund as investors shunned credit risk and chose traditionally safe government funds.
The Federal Reserve announced a major expansion of lending programs to include corporate and municipal debt. The Fed launched a lending facility to backstop Prime money-market funds and those funds were overwhelmed with large redemptions as investors transferred their money to Government/Treasury funds
Fiscal Rescue Package
At the end of March Congress passed the CARES Act, a $2.2 trillion rescue package. The support for the most severely impacted corporations comes through a $500 billion addition to the Treasury’s Exchange Stabilization Fund. But most of the $425 billion will ultimately be used for first-loss parts in Federal Reserve facilities. Assuming 10-to-1 leverage, this allows for an additional $4+ trillion of monetary policy activities to support the flow of credit to small and medium sized businesses. The estimated total support to the economy provided by the fiscal package is almost $6 trillion, or almost a third of GDP.
Unemployment
Over the last three weeks of March, almost 17 million people filed for unemployment claims. The CARES Act (Paycheck Protection Program) was designed to save jobs and prevent furloughs. Instead large companies chose to furlough employees and preserve cash. Unemployment is expected to grow to higher levels than during the Financial Crisis.
GDP
GDP projections deteriorated. Current expectations are for the annualized GDP to be -24% in 2Q2020, -10% in 3Q2020, and flat for 4Q2020. The market already expects poor earnings or losses to be reported by many corporations throughout 2020.
US Treasury
Treasury yields dropped by 63 basis points (bps) in the 2-year, 52 bps at 5-years and 43bps in 10 years.
While Treasury yields declined during March, the yield curve steepened after the Fed intervened to shore up market liquidity. The Treasury will need to fund the government’s fiscal $2.2 trillion rescue package and will likely issue Treasury bills. Short-term Treasuries had negative yields by the quarter-end. The Secured Overnight Financing Rate (SOFR) dropped to 0.01% by quarter end.
Corporate Bonds
During the last full week of March, investment grade corporate issuance hit a record high of $110 billion. Corporations responded to the new low interest rates by issuing bonds to replace their commercial paper whose market had seized up as Prime Funds saw large redemptions.
Credit spreads widened with BBB-rated securities seeing the largest spreads. Overall corporate bonds underperformed similar-duration Treasuries in March due to credit downgrades, spread widening, and the flight to Treasuries.
Forecasts for corporate earnings and economic growth dropped sharply due to demand destruction resulting from the quarantines.
With reduced economic activity and demand, U.S. corporate cash flows and profits are expected to drop in 2020. Many corporations that were already leveraged will now appear even more leveraged due to reduced demand. Companies are starting to reduce capital expenditures, decrease share buybacks and some have cut dividends in an effort to maintain financial strength.
Credit Downgrades and Fallen Angels
The ratings agencies have aggressively downgraded many credits by evaluating them on an industry basis. Large swaths of credits are suddenly and rapidly being placed on Watch or downgraded such as the banks in Australia, New Zealand, Japan, UK, Netherlands, Switzerland, Sweden and Canada. Defaults and problem loans are expected to plague banks.
Other industries targeted by the rating agencies for downgrades were US oil-related companies, European oil and gas companies, the automotive industry and their finance companies. Moody’s Investors Service revised its outlook on the U.S. investment grade corporate market from stable to negative in March 2020.
In March alone, $235 billion of corporate debt from 32 U.S. investment grade issuers was downgraded which is three times the number of downgrades in February. Barclays reported that the highest monthly number of downgrades from BBB to below investment grade BB, creating “Fallen Angels,” occurred in March 2020. This is the reason the Federal Reserve expanded its purchase program to include the high yield bonds of Fallen Angels to support the bond market.
Oil
Oil plunged to $21 per barrel as the Saudi-Russian price war continued among lower demand driven by the quarantines and shutdowns. $30/barrel is a key price for energy companies to operate. US shale producers need $50-$55/barrel to maintain production. The high yield bond market already consists of bonds issued by small energy-related companies.
There are BBB-rated oil related companies that may also be downgraded to below investment grade, joining the growing list of Fallen Angels.