Europe continues to be the poster child for understanding why central banks should avoid negative rates as a policy tool.
Toward the end of 2019, there was growing media chatter about the potential for negative interest rate policy in the United States. At the time, the idea was more of an abstraction of a longer-term potential outcome. There was no immediate reason for the Federal Reserve to bring its target rate below zero, rather the possibility existed down the road as the U.S. economic slow-down materialized over time. Our stance then was that we did not want or need negative rates in the U.S. Of course, that was before the COVID-19 pandemic sent the global economy into a short-term tailspin. While our view on negative rates remains the same, this question has recently made its way back into the headlines and some market participants in the Federal Funds futures market are also speculating on the possibility.
Federal Reserve Chairman Jerome Powell has repeatedly stated that the central bank is not considering cutting rates below zero, stating in an interview recently, “I continue to think, and my colleagues on the Federal Open Market Committee continue to think, that negative interest rates is probably not an appropriate or useful policy for us here in the United States.” He also stressed that the Fed has not exhausted its options for aiding the economy, pointing to the ability to increase its emergency lending programs and adjust its asset-purchase strategies. We agree, and believe that the Fed will use every other tool in its arsenal to further loosen monetary conditions before turning to negative interest rates.
In short, negative rates ultimately stymie a central bank’s ability to respond in a downturn. Europe continues to be the poster child for understanding why central banks should avoid negative rates as a policy tool. Despite the European Central Bank’s aggressive use of negative interest rates, their economy has simply not generated any meaningful amount of growth or inflation. Instead, consumer savings rates trended higher, the profitability of euro zone banks suffered, and pessimism about the ECB’s ability to manage through this downturn has increased.
Past performance is no guarantee of future results. Source: Bloomberg, Bloomberg/Barclays, JP Morgan and Voya.
Bond Market Outlook
Global Rates: U.S. rates to trade range bound
Global Currencies: U.S. dollar to weaken against DM, EM currencies
Investment Grade: Heavy supply to be mostly absorbed by strong inflows, but we expect spreads to trade sideways in near term
High Yield: Long term valuations offer attractive entry point despite recent rally; material default cycle inevitable and recovery will be uneven
Securitized: Fundamental risk remains elevated, but as fiscal, monetary stimulus filter through economy and TALF becomes operational, set up for Securitized seems favorable
Emerging Markets: EM benefitting from stimulus measures coordinated by G20, IMF to minimize liquidity shortfalls and potential defaults
Global Rates and Currencies
The global economy is finally showing signs of working its way off the bottom of a trough, as many countries are loosening restrictions and opening partially. Notably, countries in Asia - such as China, South Korea and Taiwan, which imposed lockdowns or closed their borders earlier - have eased restrictions. As such, activity has started to bounce back but is still well below January’s level. Meanwhile, European countries, such as France, Germany and Spain have outlined their own respective parameters for reopening, with some more stringent than others.
Overall, Monetary policy remains loose, but neutral rates have also come down significantly, a dynamic that should reduce inflation risk concerns. That said, the Federal Reserve, rightly so in our view, remains worried about deflation risk, given unprecedented level of demand destruction in the economy due to COVID-19. We believe the only risk to headline inflation comes from food prices: From meat plants in the U.S. and Ireland to harvesting fruits and vegetables in India, labor shortages are becoming more apparent and transportation shortages make it more challenging to get farm produce to market.
While the U.S. fiscal deficit is likely to climb as high as 20% of GDP, we are concerned it could increase even further, as we’re expecting another trillion dollars of stimulus to address municipal and small business needs if lockdowns extend beyond eight weeks. That said, while we expect peak to trough GDP growth decline to be around 15%, we are seeing signs of bottoming as restrictions have been eased.
We also note that the Fed is currently debating the merits of Yield Curve Control versus classic Quantitative Easing, which will move the focus from market functioning to easing financial conditions through portfolio rebalancing. We expect the 10-year yield to tread in the 0.50% - 1.00% range, with a bias towards the higher end of the range as investors gain more clarity over the economic impact of the virus.
Investment Grade (IG) Corporates
Against the backdrop of unprecedented drop in economic activity having been met with unprecedented fiscal and monetary stimulus, the Investment Grade Corporate market in April staged a strong come back from March, with outflows becoming inflows. Aside from spreads rallying in the overall market, concerns related to front-end yield curve inversion were bought under control when the Federal Reserve announced primary- and secondary-market bond buying programs, volatility subsided, and sentiment improved during the month.
New issues continued to flow, as issuers with higher credit ratings and those rated triple-B tapped the market to shore up liquidity. Going forward, we note the risk of fatigue, as supply flow continues to set new monthly records, e.g. April new issuance exceeded March’s record-breaking volume. Elsewhere, fundamental input will continue to be hard to gauge, as we have seen so far from companies that announced first-quarter earnings, with most companies pulling back from providing guidance. High quality spreads have compressed meaningfully, with pockets of opportunity in BBBs with strong business models and manageable leverage. Over the near term, we expect spreads to move sideways and provide an attractive risk-reward opportunity.
High Yield Corporates
The rally that began at the end of March extended through April following the Fed’s announcement that Fallen Angel’s and high yield ETF’s would be included in buying programs. Overall, demand was cautiously robust, as new issues and Fallen Angels were absorbed. That said, the combination of the newly Fallen Angels and a rise in defaults is shifting the composition of the index, with the higher-rated portion expanding. Looking ahead, fundamentals will generally be highly challenged over the short-term, but the market does seem to be focused on the longer term and appears comfortable with the outlook. From a technical standpoint, interest rates are low, equities are strong, cash is flowing into the market and the fallen angles are finding buyers, all off of which could change if supply – i.e. new deals and fallen angels - begins to overwhelm.
Quantitative Easing restored calm in the Agency RMBS market, as the unprecedented pace of asset purchases tilted the supply-demand dynamic favorably and drove the sector to outperform. However, Agency RMBS performance over the next few months will depend on a confluence of ongoing dynamics: While the Fed’s purchasing program provides a significant tailwind to MBS performance, the low interest rate environment puts the sector at risk of a large refi event. Although the forbearance measures currently in place should limit refinancing, uncertainty remains high from a prepayment and economic standpoint.
We hold on to our positive tactical outlook for the non-agency RMBS market as low rates, reasonable fundamentals, and improved relative value should support the asset through these choppy waters. Any correction on housing values in mortgage indices will be a second or third order impact of the current crisis, and not challenge the value proposition of housing.
Meanwhile, we remain cautious on select pockets of CMBS over the short term, as the economic impact of the COVID-19 pandemic places commercial real estate directly in the crosshairs. While valuations in some parts of the CMBS sector appear attractive on a relative and historical basis, we expect that uncertainties regarding the duration and severity of the economic fallout, combined with greater idiosyncratic risks in commercial real estate, will impair risk taking in these segments. Although backward looking fundamental metrics continue to register positive, dramatic change is forthcoming, as the damaging implications from the pandemic for parts of the CRE universe - such as student housing, hotel and retail, and potentially office and multifamily longer term - are undeniable.
With the COVID-19 pandemic altering the overall characterization of the sector and therefore conjuring a new and overpowering actor in the form of the Federal Reserve, we are taking a positive outlook in anticipation of TALF operational details emerging in the coming weeks. Consumer related sub-sectors will most directly benefit. Overall, the strength of the U.S. consumer heading into the pandemic coupled with ABS structural dynamics provide the sector with relatively solid footing to withstand the eroding fundamental backdrop.
Emerging Market (EM) Debt
Thus far in 2020, EM GDP negative growth is being exacerbated by a standstill in domestic activity and a slump of international trade related to the global economic recession. Over the short term, inflation will likely fall further across Emerging Markets with few exceptions due to collapsing domestic demand and lower commodity prices. Furthermore, food inflation will likely remain volatile. Longer term, the shape and magnitude of any rebound is largely dependent on the confinement and re-opening timeframes across applicable EM states, as well as public policy approaches to the pandemic.
Past performance does not guarantee future results.
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.