Bond market - V looks W shaped to me

Jonathan Sheridan

FIIG Securities

Following on from our assessment a month ago about the likely path of a post COVID-19 recovery, we update the recent macro data and look at bond market options. 

Updating the data 

As a reminder, world trade growth had been declining and was actually negative prior to the impacts of coronavirus shutting down many world borders:

Source: Hoisington Capital Management

The World Trade Organisation has updated the data and made some projections based on three different scenarios, although to be honest when even the pessimistic scenario envisages a recovery to the end of 2019 levels by the end of 2021, I suspect even those are too optimistic:

Source: WTO/UNCTAD and WTO Secretariat estimates

Note the optimistic scenario assumes a reduction on trade greater than the equivalent period in the GFC…

From the lows in data in mid-March to April, there has certainly been an improving trend, as expected given the economic impacts of the shutdowns were always likely to be reversed when movement of people was allowed again. The question has always been what might the level of permanent damage to the economy be? Even with these improvements, the Atlanta Federal Reserve’s GDPNow predictor is showing a 36.8% contraction in US Q2 GDP, up from -52.8% in the 1 June update of the model: 

For context, the deepest contraction in US GDP during the GFC was in Q4 of 2008, when the rate of contraction in the US economy was -8.4%.

China is further along the curve in terms of dealing with the virus and its effects. The measure of broad business activity are the PMI indices.

Remember that PMIs are diffusion indices – so 50 means the same level of activity as last month. The above shows that the majority of firms are only showing a slight increase in activity from February lows, not recovering to pre-COVID levels.

Unemployment is still at extreme levels. In his press release with the RBA cash rate decision on the 7th of July, RBA Governor Lowe used the word ‘unprecedented’ to describe the number of jobs lost during the shutdown, and went on to confirm this number would have been even higher had the government not applied its historic support programs.

Source: Australian Bureau of Statistics

Perhaps even more important than the absolute number of people without a job is the people who even if employed (defined as working just 1 hour per week) are working less than they want to – the “underemployed”. This rate was rising even before the virus hit and shows there was a large and growing amount of spare capacity in the labour force, even as the headline unemployment rate was declining from 2014 onwards.

Inflation typically declines during recessions – on average over the last 30 years by between 4-5%. With inflation in the December quarter of 2019 starting at just 1.8%, this does not bode well for the likely future path of inflation and the economy. After all, if you can buy something cheaper in a few months then why would you buy it today?

Source: :

Debt by definition, is bringing consumption forward from the future to today, which is why the central banks lower interest rates so much – to make it more attractive to borrow and spend today rather than save and wait until there is sufficient cash on hand to spend on an outright basis.

This is fine in theory as long as the debt is used in a productive manner, which produces a cashflow that is enough to pay off the interest and principle over time.

This principle underpins why central banks have to go further and buy debt in the market – to keep market yields from rising which would further disincentivise spending as the cost of debt becomes prohibitive.

The RBA has grown its balance sheet, buying government bonds, at the fastest pace in history:

Source: Reserve Bank of Australia

Central banks globally have also extended the types of bonds they will buy from government risk only to corporate bonds. The RBA will accept investment grade corporate bonds into its repo facilities, significantly boosting secondary market liquidity.

Bond market update:

Corporate yield curves have steepened, as the RBA have anchored rates at the short end with their bond buying program. Longer end yields have risen, reflecting the uncertainty associated with the exit from the virus impact. 

Source: Bloomberg, Australian AUD A-rated corporate yield curve

At the same time, as cash rates have declined, so have the rates banks are willing to pay on term deposits, although these are still well above where banks can borrow in the institutional market, reflecting the desirability of term deposits due to their ‘stickiness’.

Source: Reserve Bank of Australia

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Director, Fixed Income & Investment Strategy
FIIG Securities

Jon is FIIG Securities’ Chief Investment Strategist. Also a Chartered Accountant, Jon has been working in multi-asset class investment markets for over 15 years, and now specialises in providing fixed income solutions for FIIG’s clients.

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