I’m probably not alone thinking that 2020 is starting to feel like the longest year ever. We are only just approaching the half-way point. With two more trading days to go in the quarter, the markets seem to be closing on a soft note. Global equities dipped this week on renewed fears about 1) rising COVID infection rates in the U.S., and 2) the possibility of more trade battles heading into the fall election. Conversely, bond yields dipped again with the 10-year and 2-year falling to 0.64% and 0.17% respectively.
Risk assets have had a good rally since the March lows, so a period of churning makes some sense. But almost certainly the story of the third quarter will be dominated by three big issues: 1) where do infection rates go over the coming weeks, 2) will we see more fiscal and monetary support (especially if infection rates continue to flare up), and 3) what policy changes are introduced ahead of the election this fall? The year is only going to get longer.
In terms of economic reports, there were only a couple significant ones. First durable goods orders increased 15.8% month-over-month in in May but remain down -17.9% year-over-year. Core orders (excluding transportation) are down -6.3% year-over-year despite a +4% bounce in May, as you can see below.
This is similar to what we have seen in Purchasing Managers Surveys around the world. A steep post-COIVD drop followed by a bounce.
But the bounce isn’t coming close to recapturing historic highs, at least in Europe and Japan. As MRB notes:
“However, these surveys do not capture the magnitude of the recovery relative to the deep hole created during the lockdowns, nor whether the outlook will improve sufficiently to return corporate profits to pre-COVID-19 levels by next year.”
The other main report concerns inflation. The Fed’s favored gauge of inflation came in at just +0.55% May, while the core (excluding food and energy) was +1.02%.
The inflation data ties in with an evolving view of future Fed policy. In the last few days the Fed’s balance sheet has stopped growing, in large part because the emergency measures they put in place a few months ago are not being fully utilized.
But the Fed clearly remains concerned – just witness Thursday’s move to control bank dividend payments and share buybacks. The Fed has succeeded in driving real yields negative, as you can see below. This chart in essence shows you the yield on the 5-year Treasury bond after inflation. The suspicion is that in a perfect world the Fed probably want yields even more negative.
So, what is next? Probably something called Yield Curve Control (YCC). This is where the Fed would pledge to keep yields at a certain maturity at or below a given rate. For example, the Australian central bank recently said they’d run policy to keep three-year government bonds at around 0.25%. The Bank of Japan has been targeting 0% for their 10-year bond for a number of years now. The betting is the Fed follows Australia’s example and targets shorter-term yields.
The Fed has implemented YCC in the past. To help the Treasury fund the Second World War in 1942, the Fed set the short-term Treasury bill rate at 0.375% and capped the long-term government bond yield at 2.5%. The short-term target ended in 1947, but the cap on long-term yields didn’t end until 1951.
What are the downsides of YCC? A Brookings Institute study looked at the question and boiled it down to inflation and a loss of credibility:
“Like other unconventional monetary policies, a major risk associated with yield-curve policies is that they put the central bank’s credibility on the line. They require that the central bank commit to keep interest rates low over some future horizon; this is exactly why they can help encourage spending and investment, but it also means that the central bank runs the risk of letting inflation overheat while holding to its promise. If the Fed, for example, were to commit to a 2-year peg, they would be betting on the fact that inflation will not run well above its 2 percent target in that period. If it does, the Fed may have to choose between abandoning its promise about the peg or not holding to its stated inflation objective—both bad options in terms of its credibility with the public.”
The next Fed meeting is at the end of July, probably about the same time another round of fiscal support is likely to take form.
Charts We Found Interesting
1. No second wave in the ‘old hotspots’, but the first wave never really ended in the ‘new hotspots.’
2. Texas closed the bars again as hospitalizations soar.
3. There is an interesting dichotomy between case growth for the U.S. as a whole….
…and mortality rates.
4. There’s much going on that experts don’t understand. How much is increased testing playing a role in case growth?
Also, what does the fact that new cases are skewing towards younger people mean for hospitalization and mortality trends? (https://www.npr.org/sections/coronavirus-live-updates/2020/06/22/881734964/florida-passes-100-000-covid-19-cases).
Goldman seemed to capture the current situation well:
“Worsening performance in mitigating virus spread, and consequently diminishing hospital capacity have pressured some states to reconsider their reopening plans. Yesterday, the Texas governor announced the state is suspending certain elective procedures in four large metropolitan counties with low available capacity in an effort to preserve resources. State and local officials say that renewed lockdowns are a policy of last resort, and this order from Texas shows that states can at least initially respond in a more targeted manner.
But the state also joined a handful of others across the country in pausing, but not reversing, its reopening plans. The phased-in nature of reopening over the past several weeks shows that state and local governments can tailor restrictions to meet varying situations across a state. But even if a broad lockdown is not a policy option currently on the table, postponing further reopening would still weigh on economic activity, especially if such announcements trigger heightened voluntary caution from consumers and businesses. Further targeted restrictions in Texas and other states may become necessary if case growth continues to spread while available hospital capacity diminishes.”
5. Let’s take a stab at three possible secular changes to the global economy and investment backdrop due to the COVID crisis. First up – commercial real estate. It is interesting that office vacancies haven’t increased much during the COVID lockdown. Is it simply a matter of time before more and more companies give up on their leases and move to a work-from-home model?
6. Another possible secular change concerns air travel. How much will come back without a vaccine? At least in the U.S., consumers are understandably choosing to drive rather than fly this summer.
7. A final stab at a possible secular change – globalization goes in reverse. Chart below shows that the fall in global trade this year is projected to be twice the fall in global GDP. To the extent we all try to onshore production, will this trend be with us for a number of years?
Have a good weekend.
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