When nothing else could derail risk markets, along comes the coronavirus (COVID-19). At this point, it is unclear what the ultimate human and economic impact of the virus will be, but downside risks abound. The market response has been to sell risk assets and buy the safety of U.S. Treasuries in a classic flight-to-quality trade. The S&P 500 is down -12.7% from the February 19th record close and is now down -8.27% for the year. Meanwhile, the yield on the 10-year U.S. Treasury fell 40 basis points to a new all-time low of 1.11% and is down 77 basis points for the year.
From a return perspective, investment grade bonds benefited nicely from the dramatic move lower with Treasuries 1 producing positive monthly and year-to-date returns of 2.65% and 5.16%, respectively. The broader Bloomberg Barclays Intermediate US Government/Credit Index returned 1.41% for the month and 2.85% year-to-date. There was no such silver lining for the equity markets as the selling was aggressive and broad-based. Meanwhile, the high yield bond market 2 was down slightly for the month (-1.54%) and year (-1.53%); it faired significantly better than equities thanks to the positive price appreciation from the move lower in interest rates in the broader risk off environment.
To us, the most amazing part of the recent equity market correction is not the magnitude or velocity of the price swings, but instead the instantaneous clamoring from market participants for additional Fed stimulus, emergency rate cuts, coordinated global easing and yes even another round of tax cuts from the Trump administration. What would they ask for if equity markets sold-off 20-30%? These types of reactions to a 12% market correction speaks to a much bigger issue in today’s financial markets that we’ve been talking about for years. Namely, the markets’ dependency on easy money. It’s an issue. The Fed knows it, but they don’t know what to do about it.
To be sure, additional easing from the Federal Reserve is not going to solve the coronavirus outbreak. Additionally, they have been clear that monetary policy is on hold until there is a material reassessment to the economic outlook or inflation is significantly and persistently above their 2% target. To date, neither has happened. Of course, markets are forward- looking and pricing in the future negative impact of the coronavirus, thus asking for easing today. We do not envy the Fed’s position. Trying to set monetary policy during a period of market turbulence, sparked by a novel virus that nobody knows a thing about, is challenging to say the least.
If the virus gets materially worse from here, the negative economic implications will be undeniable and unavoidable. The Fed would be forced to ease policy further, attempting to spur a stalling U.S. economy. However, if the Fed chooses to preemptively respond and the economic outcome turns out to be less dire, then their…