Fixed income.gov: getting acclimated in a world of government-managed debt

Today, it’s anything but business as usual across global fixed-income markets. Price swings of 20% to 25% in a month are normally thought of as a bad month for stocks, but these days, that sort of price volatility could be used to describe a long bond. Price volatility isn’t the only oddity in the bond market. Consider that in mid-March the Canadian government long bond was yielding 74 basis points.¹ Or consider the case of Austria, which has a 100-year government bond (that’s right, a bond that matures a century from now) yielding just 40 basis points.² If you thought the equity market was volatile, welcome to fixed income!

Of course, this implausible-sounding volatility is a side effect of the COVID-19 pandemic, which has brought the global economy to a grinding halt. The weight of this imposed economic stasis was simply too much for global fixed-income markets to bear, and so it shouldn’t be surprising that it brought about a quick-onset liquidity crisis.

Near-total stasis in most sectors continues to be destructive to the global economy, which, in the pre-pandemic world, was reliant on the interconnectivity of people and countries to drive GDP growth. Indeed, social distancing and closed borders—the measures required to combat the spread of COVID-19—essentially stand as an inarguable antithesis to the fundamentals of economic growth.

That’s why the recent volatility and the gathering economic damage are so different from what we’d encounter in a “normal” crisis, and why they require a radical government-led response—something that we believe is ultimately likely to go far beyond what developed-market governments implemented in the wake of the 2008/2009 GFC.

Social distancing and closed borders—the measures required to combat the spread of COVID-19—essentially stand as an inarguable antithesis to the fundamentals of economic growth.

It’s important to review how we got to where we are today, if only to understand why the changes that have happened so quickly aren’t likely to reverse course anytime soon. With the explosion of economic uncertainty in March, traditional correlations broke down. At times, equities were falling quickly, and so were bond prices. Investors couldn’t rely on conventional bond allocations to provide the expected performance buffer.

As it happens, bond market liquidity was facing a multiweek period of unprecedented constraint, especially for short-dated corporate bonds. Specifically, we experienced a dramatic flattening of the credit curve as short-dated paper was used to fund a sudden rush for liquidity and as the market experienced a rapid leverage unwinding. The bond market was unable to trade, and companies were unable to raise required capital. It was in this context that developed-market central banks cut interest rates to near zero, instituted emergency programs to aid market liquidity, and embarked on unprecedented rounds of quantitative easing to support asset prices.

The Bank of Canada (BoC) rolled out more than a dozen different programs in three weeks, including facilities to purchase commercial paper, as well as government and corporate bonds—and this could be just the beginning. The U.S. Federal Reserve (Fed) has also adopted a “whatever it takes” response, surpassing in a matter of weeks some measures that had taken months to establish during the GFC. Fiscal deficits have also ballooned, and commentators have used World War II as a relevant analogy to approximate the financial conditions of our current global situation.³

A critical problem that central banks have tried to tackle head on is how to ensure that a liquidity crisis doesn’t become a full-blown credit crisis—and to do that before the depth of the economic contraction arrives. Lower-rated BBB securities, for example, experienced enormous pressures before government stimulus was passed, with bid-side liquidity severely constrained or nonexistent. Energy producers, pipelines, specialty financials, autos, and real estate all experienced sudden and dramatic weakness. Even large bank paper was under pressure, reflecting the extraordinary demand for liquidity amid the fever pitch of uncertainty.

Given the pressures on liquidity and credit, it comes as no surprise that governments used everything in their toolkits, and even created new tools, to forestall a deepening of the crisis. Potentially unlimited quantitative easing, a sentiment expressed by the Fed, is an unprecedented response from any central bank, but we think it’s the right response if market normalization is to occur anytime soon. And on the fiscal side, it’s perhaps the only option available if governments want to avoid more harmful, long-term destruction of productive capacity.

At the beginning of 2020, we were facing a world of low growth, low inflation, and historically low interest rates. The tepid global macroeconomic environment led us to conclude that valuations were virtually the only thing that was high. We were accordingly cautious on risk within our portfolios and calibrated our exposures to navigate a plausible environment in which equity markets corrected in the range of 15%, with a corresponding correction in spread markets.

I’d be the first one to tell you that we don’t try to time the market. It’s not what we do. We are disciplined investors who focus on valuations and fundamentals. We were simply following our investment process when we had de-risked going into the crisis. We thought valuations were rich and, as such, had reduced spread risk in our strategies. So, in essence, we were positioned to weather something like a Category 1 hurricane. But when the storm hit, we suddenly realized we were in a Category 5.

Even now, as we begin to see opportunities emerge in investment-grade corporate credit and elsewhere, we’re still cautious from a fundamental and market dynamics perspective. The fundamental narrative, as we’ve discussed, is defined by weak and uncertain global growth, weak and uncertain earnings growth, potentially significant pressure on corporate balance sheets, and the potential for bankruptcies in certain sectors. Market dynamics are characterized by liquidity strains, as evidenced by ongoing unconventional central bank announcements; selling pressure from exchange-traded fund redemptions; and the potential for further leverage unwind, which could lead to widespread selling across asset classes.

We were positioned to weather something like a Category 1 hurricane. But when the storm hit, we suddenly realized we were in a Category 5.

In the short term, we’re paying close attention to the signals offered from short-term money markets. We believe this is one of the best places to read the liquidity signals that have become so relevant across the full spectrum of fixed-income asset types. On a daily basis, we gather information on the strength of short-term liquidity and the operational progress made by the BoC’s purchase programs, which allows us to formulate a picture of how the liquidity landscape is evolving. And while there has undoubtedly been improvement on the liquidity front, there’s still progress to be made in terms of short-end spread tightening and product availability. Changes we see there will affect how we assess risk and deploy capital in virtually every other fixed-income sector in the months ahead.

Taking a longer-term view, we’ll be watching for further changes to fiscal policy. As the financial and economic crisis progresses, we’ll carefully assess whether we have in fact entered a new fiscal policy regime. How will governments think about running deficits in the quarters and years ahead? Because our strategies incorporate government bonds as sources of return, changes in overall issuance will be important to analyze closely. If Ontario, for example, far exceeds its normal levels of issuance, that may imply a substantial change in our spread expectations for that province’s debt. When viewed from a historical perspective, spreads at a certain level may suggest they’re cheap, but if you believe you’re in a new regime for fiscal policy and expect higher average deficits, then you need a new scale for measuring cheapness.

1 Bank of Canada, data as of March 9, 2020. 2 Bloomberg, data as of March 16, 2020. 3 See, for example, “Bad Economic Theory and Practice, Demolished,” prospect.org, April 6, 2020.