“Knowing reality means constructing systems of transformations that correspond, more or less adequately, to reality.” — Jean Piaget
“We’ve got facts, they say. But facts aren’t everything, at least half the battle consists in how one makes use of them!” — Crime and Punishment, Fyodor Dostoyersky
A short one this week.
The formal definition first.
Duration is a measure of the sensitivity of the price of a bond (or more accurately, any financial instrument) to a change in interest rates. Duration is non-linear and accelerates as time to maturity diminishes, i.e. financial instruments become less sensitive to changes in interest rates as maturity draws closer.
Duration: Now What?
At the start of the year, we advised “Using rallies to reduce equity exposures tactically and increase bond allocations”. This prescription was based on our assessment of the lay of the land prior to the global spread of Covid-19.
The coronavirus has hastened the rush into safe haven assets, pushing 10-year US Treasury yields to all-time lows — 1.2 per cent is the most recent print. Notably, the other safe haven asset, German 10-year bunds, has also followed suit. At the same time, global equity markets are on track to have their worst week since the Global Financial Crisis.
The global spread of the Covid-19 virus has revealed the glaring fragility of the globalised world we live in. As discussed last week, the suspension of Chinese manufacturing has revealed the deep rooted interdependencies within global supply chains — much like the interdependencies between global financial institutions revealed by the Lehman bankruptcy. Given these interdependencies, it is no surprise that there is panic and investors are rushing into safe haven assets.
The corollary of the rush into safe haven assets is that pension managers, already facing an asset-liability duration mismatch, are forced into buying ever more bonds as long-term yields decline. This need to buy an increasing amount of bonds, precipitates a vicious feedback loop — increasing demand for bonds begets further demand for bonds, pushing yields lower and lower. Making bonds the ultimate momentum trade.
It may only be a matter of time before we see a US 10-year yield print with a 0 in front of it.
The long-end is not the only part of the yield curve where the action is. According to The Wall Street Journal:
Federal-funds futures, which traders use to bet on the path of central-bank policy, showed Thursday afternoon that investors thought there was a 72% chance the Fed will lower its key policy rate by a quarter-percentage point at its March 17-18 meeting, according to CME Group data. That was up from just 9% a week ago,
Investors also saw an 83% chance the Fed will cut rates by at least 0.50 percentage point by the end of its July meeting and a 46% chance it will cut rates 0.75 percentage point by that time.
Markets are pricing in short-term US rates heading toward the zero-bound once again. The Fed, publicly at least, is not yet entertaining the need to further ease monetary policy.
In a speech Tuesday, Fed Vice Chairman Richard Clarida said disruptions from the viral outbreak in China “could spill over to the rest of the global economy” but that it is too soon to “even speculate about either the size or the persistence of these effects, or whether they will lead to a material change in the outlook.”
History has shown that once the market starts pricing in rate cuts, it is only a matter of time before the Fed follows through. The longer the Fed fails to communicate as much, the lower the equity markets will go.
It is not a Monetary Policy Issue
The argument against the Fed, or any other major central bank, easing policy is that the global spread of the Covid-19 is not a monetary policy issue. That is, looser monetary policy will not remedy the forced slowdown in global economic activity.
That is true. Governments will most likely have to introduce some form of fiscal stimulus to counter the lobal slow down. Fiscal stimulus, we think is unlikely to be instituted, until and unless monetary policy has been loosened to the extent that it (a) cannot be loosened further or (b) proves impotent.
The Contrarian View: Not Just Keeping Powder Dry
The global economic slowdown is priced in. A sell-off in equity markets is warranted. The question, as always is, how to position for that which is not priced in.
The last decade witnessed long-duration assets, with stable and almost annuity-like cash flows, being bid-up. Be it developed market bonds, corporate credit, technology companies such as the FANGs, software stocks with subscriptions-like revenues and consumer packaged goods companies such as Procter & Gamble.
With equities falling out of favour in the interim and long-term rates collapsing, we think the market is being primed for an almighty rally in stocks with long-duration like attributes. This view is predicated on (1) a vaccine for Covid-19 being found and (2) the Fed easing monetary policy.
Till such time we recommend keeping most of your powder dry and gradually adding high quality technology companies (such as Facebook) to your portfolios. Once the above conditions are met, there may even be room to jump into beaten-up cyclical sectors — energy, industrials and materials.
Thank you for reading!
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.