Think Big: As the corona crisis worsens, pay attention to the bond market
Link copied to
When major stock markets crash more than 20 per cent in less than three weeks, it’s sending a pretty clear message that something is wrong.
As a forward-looking indicator, equities are a mechanism to value future returns.
And with markets now assessing the prospect of more major economies effectively going into an Italy-style lockdown, those returns are being fundamentally re-rated.
But history shows that for major corrections like this, the first clues to the crisis often appear in the bond market.
For starters, it’s huge; fixed income securities denominated in US dollars form the basis of an asset pool totalling around $US50 trillion.
At the end of last year, the market capitalisation of the S&P500 as a whole was just over $US28 trillion.
Secondly, government bond yields are a guide to future interest rate expectations, which in turn have a strong bearing on stock valuations.
So what was the bond market trying to tell us in the lead up to the March meltdown? Stockhead spoke to CBA’s head of fixed income and currency strategy, Martin Whetton, who said it was an indication that trouble was afoot.
“Bond markets had been falling in yield terms for the previous couple of weeks, well before the equity market saw the problems ahead,” he said.
Bond yields move inversely to their price, so when yields are falling it means bonds are in demand.
Yields on US 10-year treasuries — regarded as the global benchmark — spent most of the last six months above 1.7 per cent, but first started falling in late-January.
“Bonds were saying there’s going to be low growth, low inflation and the probability of rate cuts coming in Australia, the US and Europe,” Whetton explained.
“Part of the expectation was that rate cuts would happen in those jurisdictions and that would lift equities.”
“But once the realisation dawned that COVID-19 was the bigger issue, equity markets started to catch up with what the bond market was saying.”
Once the bond re-rating was complete, the entire US yield curve — all the way out to 30 years — was below 1 per cent for the first time in history.
Yesterday, markets awaited a speech from President Donald Trump to provide details on the US government’s stimulus plan.
Markets were hoping for more fiscal firepower, while Trump also put a flight ban on the whole of Europe — an unexpected announcement which sent equities into another dramatic tailspin.
As the crisis worsens, investors will also be looking to the corporate bond market for more signs of trouble ahead.
After more than a decade of low rates and cheap money, risks surrounding leveraged excess in pockets of the corporate debt market have been lingering for a number of years now.
And as markets melt down, signs of stress are beginning to emerge. One metric that will be worth watching is the spread between yields on investment-grade corporate debt and benchmark US treasuries.
Before Trump’s speech, the spread had widened to more than 180 basis points — the highest level since 2016.
“Through the first part of this move, the widening in large part reflected the rapid shift downwards in the risk free (government bond) curve,” RBA deputy governor Guy Debelle noted earlier this week.
“In the last few days though, we have seen yields rise along with the spreads.”
Debelle said bond issuance had been low, partly because companies “do not want to appear to be in desperate need of funds in a dislocated market”.
At the same time, major companies in the hardest hit sectors, such as airlines and hospitality, are being forced to draw down on their existing credit lines.
Bloomberg reported that Boeing plans to draw down the full amount of a $US13.25bn credit facility to deal with travel disruptions. A number of oil companies are also under pressure.
“Any equity investor should look at the credit market because it’s effectively the other side of the balance sheet,” Whetton told Stockhead.
“There’s been a significant widening in spreads, and it’s getting wider. That’s making it harder for companies to raise capital, but it’s more than just that — it’s a liquidity issue as well.”
At the time of print, uncertainty around the spread of coronavirus is still increasing rapidly. In that environment, dislocations in credit markets are likely to be a precursor for more pain in stocks.
In the meantime, global central banks have indicated they have more tools to deploy as the economic fallout rises.
The US Federal Reserve has started providing emergency short-term funding to US banks and the RBA stands ready to do the same.
But if markets remain unable to price the risk event caused by coronavirus, more aggressive quantitative easing measures may be required.
With further chaos seemingly inevitable, price action in the bond market will likely be the most important early indicator to what happens next.