A close look at the treasury market is showing that investors are terrified of a recession sparked by the coronavirus.
Stocks continued their massive sell-off Friday, with all three major U.S. indexes down more than 3%. After an ugly correction last week on the back of the coronavirus global spread, stocks bounced Wednesday, which many strategists thought would be more sustained than it was.
But after another week of net selling, the S&P 500 is back down 14% from its all-time high, hit in February. Needless to say, the market is back in correction territory.
And while this newsletter will point out that the bond market looks just as scary, if not scarier than the stock market does, one point on stocks does need to be addressed.
The U.S. market is seeing harsher selling in light of the virus than it did during other outbreaks, namely SARS in 2003.
The first case of SARS was in November 2002. Between November and March 2003, the S&P 500 fell 11.6%. This Coronavirus-induced drop has been worse than that one.
Still, bonds are signaling horrible things ahead for the economy.
After the Federal Reserve said it will cut its benchmark lending rate by 50 basis points -- to pad the expected recovery rather than to get nervous people and businesses out and about -- stocks actually fell. That, according to many strategists and investors, was because the Fed’s aggressive cut before its March 18 meeting signaled it thinks the economic impact to the U.S. could be worse than initially expected.
So the benchmark rate is now between 1% and 1.5%. But the 10-year treasury yield has fallen to 0.7%, with the 30 year bond yielding 1.22%. Investors are paying as much to own longer dated bonds, which have higher inflation risk, as they would to own short-term debt.
Meanwhile, February job additions in the U.S. came in at a net 273,000, beating economist’s estimates of 174,000. GDP growth for the first quarter was above 2%. Inflation should hum around 2% or just under, signaling bonds should trade at much lower prices.
Understandably, investors discounted the backward-looking data, as inflation and growth could certainly look a lot worse in the second quarter. And if the virus isn’t soon contained, Q3 may not look great either.
Another factoid investors should note is that, while stocks are signaling that this virus is scarier for the global economy than past outbreaks have been, bonds are signaling just as much.
On February 27, Commonwealth Financial Network Chief Investment Officer Brad McMillan wrote, "we are close to the point of peak fear where previous epidemics bottomed. In other words, this may be close to as bad as it gets.”
His chart showed that, on average, the SARS, Ebola, Swine flu and Avian flu outbreaks caused the 10-year treasury yield to drop 40 basis points from its year high to the low point of the market panic. On February 27, the 10-year had fallen 40 basis points from its January 17 level of just above 1.8%.
The yield now represents a more than 100 basis point drop, as investors rush for safety.
Also worth noting is the equity risk premium. That’s the expected one-year earnings yield on the S&P 500 minus the current yield on the 10-year treasury. In short, it’s the higher return investor expect from the riskier stocks compared to safe bonds.
Earnings have certainly come down and could come down in more. But currently, the equity risk premium is 5.3%, which reflects lower stock prices. But it also reflects much lower bond yields. It speaks to not only the magnitude of the sell-off of risk-assets, but also the magnitude of the run-up in price of safe assets.
To compare it to history, the equity risk premium over decades, tends to sit at roughly 3% in calmer environments.
The point: should the virus be contained soon, risk should turn back on and safety should go out of favor. Should we hit a recession, all of this may be justified.