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Sunday, March 8, 2020

Breaking Market Trends

Chart: 10-Year Treasury Yield

The secular bull market in U.S. Treasury bonds has once again resumed in full force, probably driven by short-covering. Meanwhile, risk markets are in disarray. The main question for markets is predicting when these trends will be broken. Since I do not give market forecasts, I will keep this article short, as I will just outline what I think what needs to be kept in mind.

I see two main approaches to directional market strategies here.
  1. Valuation: step in once valuations hit what are felt to be extremes (risk assets cheap, government bonds expensive). No real attempt to time the change in trend, rather the hope is to wait out the flushing of positions, and hope for a reversion to more reasonable levels.
  2. Event-driven. Waiting for some events to provide a catalyst for a change in trend; in other words, market-timing.
(Alternatively, one could look at relative value trades, which are valuation driven. Within fixed income, this is avoiding duration trades, and finding cheap/expensive corners of the market. This is probably the most sensible approach but one needs access to typically expensive market data to do this.)

Valuation

I am in the "valuation" camp, and so I would be looking for outrageous pricing. Right now, I am not convinced we are yet at such levels (although I am extremely uncertain). 
  • If we look at Treasury yields, they seem consistent with the Fed moving to a negative interest rate regime. The New Keynesians at central banks have a string, and they will push on it, no matter what else happens. Yes, almost everyone except for some die hard Ricardian Equivalence believers thinks that fiscal policy is the way out of a slowdown, but central banks do not have the legal standing to undertake fiscal policy. Since the feeling is that they have to do something, they will push on as many strings (Quantitative Easing, negative rates, forward guidance) as they can.
  • I am not the person to ask about risk asset valuations. Although the rate of change is high, we are not very far below the all-time high index valuations. Meanwhile, from what I have seen, credit spreads were not spectacularly wide (but were moving out).

Events?

Unless one feels that some sort of a silver bullet is on the horizon, it still seems early to expect a big turn around on the news flow. As has been discussed at great length elsewhere, the United States faces particularly nasty challenges for pandemic containment -- service industries that do not give low-paid workers sick leave, the cost of health care. A strategy of not testing to keep numbers down will obviously not help matters if intensive care units are overrun.

Traditional aggregate demand management (non-targeted tax cuts, rate cuts) are unlikely to do much (other than pushing down the risk-free curve). Realistically, we need to wait to see what happens, and then policymakers can undertake targeted measures to help the people and firms that are being hardest hit by the side effects of the virus. News flow is not entirely negative: some of the countries in Asia that were hit earlier by the virus have undertaken measures to appear to keep it under control. Whether the Anglo-Saxon countries have the state capacity to follow their lead remains to be determined. This uncertainty explains why I am expecting us to remain in a fog of uncertainty for a time that will feel like an eternity for risk asset investors.

Concluding Remarks

The perma-bears who have been warning about central banks blowing asset bubbles for the past decade currently have market trends working in their favour. However, it is not wise to wallow in doom-mongering. At some point, things will turn around, the only question is the price level at which that happens.

(c) Brian Romanchuk 2020

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