The Bond Market, Fed, Coronavirus and Recession

While the wild gyrations of the stock market usually capture the lion’s share of attention; something beneath the surface was happening in the bond market as a result of Coronavirus (COVID-19) pandemic.

I’ve talked a lot about the items you need to have on hand; if you unfortunately contract it.

Let’s talk about the Bond market today!

Why Is The Bond Market Important?

Personally, I track the Bond market more closely than the stock market due to the fact that the underlying data tells a much different story with respect to health of the economy.

The Bond market is more efficient due to Bond ratings, interest rate derivatives, credit worthiness, publication of bond-yield curves, spreads and the predominance of long-term institutional investors.

It is easier to manipulate stock prices especially for stocks with low liquidity. Just ask r/wallstreetbets and Robinhood infinite leverage crowd.  Much harder to do that with the Bond market.

Within the bond market, the US Treasury is more efficient and as you move away in terms of credit quality; it becomes junkier and more closely resembles the stock market.

There is a reason why traders typically look to the bond market for signs of an upcoming recession. 

Will The Bond Market Crash?

Stock Market vs Bond Market Performance

The returns for the Bond market over the last 40 years has been insane. Every time we believe we have reached a floor with respect to rates; they still go lower. A falling interest rate environment in most of the developed world has resulted in spectacular returns for bonds. 

In fact, in the last 40 years you would have received the same returns investing in the 30 year bond as with investing in US stocks.

In the past month; the 10 year has fallen by over 96 basis. For the bond market, such a large move is significant. With data going back 60 years; the only time when real 10 year yields were lower than today were during 1974/1975 and 1980. Inflation was crazy at that point and it took several rate hikes from Fed governor Paul Volcker to get inflation back on track.

Today we have low real yields comparable to high inflation periods and yet; a stable core CPI and low inflation expectations.

The Fed made an emergency 50 bps rate cut on March 3rd, 2020 to combat the weakness due to the coronavirus.

This caused rates to tumble across the board including mortgage rates.

While that action was not enough, the Fed started to buy Treasuries on March 13, 2020 across the entire curve starting with the 30 year bond.

The markets anticipated the next move and mortgage rates went back to normal levels. 

Everyone expected the Fed needed to make one cut at their next meeting in mid March. But the Fed surprised everyone with slashing rates to zero and announcing $700 billion in government and mortgage related bond purchases.

Bond Market Future Performance?

Before the March 15th, 2020 cut; the intermediate term Treasuries (average duration of 7-8 years) had around 3% upside if the 10 year yield goes all the way to zero. Now unless we go negative, which a lot of bond traders are expecting; it is hard to find a good way to make money in bonds.  

Although rates might go negative and there might be more upside; I prefer to cash out of my Bonds now. I have moved the Bond portion of my Portfolio to follow the rest of my Emergency Fund earning 8% interest

Bond markets are hard to predict. Even folks as distinguished as Former Fed chairman Alan Greenspan have been wrong. In 2017, he said there is a bubble in bond markets and not stocks when the 10 yr was at 2.3%. He believed that interest rates are at historic lows and might rise quickly. Today the 10 year is around 0.7% and might head lower.

Will Inflation rise in the future as part of the Fed action?

Effect of Fed Reserve Requirements

The most under reported part in the Fed announcement which went unnoticed was that the reserve requirements have been cut to zero. This could have massive ripple effects depending on how aggressive the banks get.

The implications of the reserve requirements are based on the fractional reserve banking. Money is now infinitely replicable. 

Some people believe that the Reserve Requirements do not have a practical effect; and are more technical in nature. If that was the case, then I’m not sure why the Fed would need to change it now?

Bottom line, banks are less likely to hoard cash when the economy needs credit and can now make more loans. 

Deglobalization effect on Inflation

As part of the COVID-19 (Coronavirus); the world has realized the extent to which it is dependent on China for manufacturing. 

Everything from masks to gloves to personal protective equipment (PPE) is manufactured in China.

Even medicines depend on chemicals which are manufactured in China. 

I predict that a shift will occur and countries will now move at least some of the critical manufacturing to their home countries.

[bctt tweet=”COVID-19 will lead to deglobalization with countries moving some of the critical manufacturing back to their home country driving up costs in the long run.” username=”FFCsocial”]

Also countries across the globe have now become more efficient in terms of closing their borders. We have even seen it in EU.  Closing borders between member nations was unthinkable a few years ago. I expect this to have long ranging impacts even post the Coronavirus (COVID-19) pandemic. 

Is Bond Market Predicting Inflation?

Based on the precipitous drop in yields; I would have expected the stock market to be a lot lower. We can see inflation all around us now.

I-Bonds are now yielding over 7%. And these are the most secure form of debt backed by the US Treasury. While I-Bonds won’t make you rich enough to create generational wealth; it is a good place to store your emergency cash for now.

In order to avoid you money losing any value it is better to invest in Income producing assets. 

Stocks usually increase in a rising inflationary environment since they have pricing power. get started investing using fee-free automated platforms like M1Finance. You can read my M1Finance review. which provides step-by-step details of how I invest.

Also real estate tends to do well. If you do not already own real estate you can invest in crowdfunding real estate platforms like Fundrise for as low as $10.

Summary

Readers, have you profited from the collapse in interest rates in your Bond portfolio? Do you plan to continue holding bonds going forward? Do you use clues from the Bond market to dictate your risk tolerance?