U.S. yields may be getting close to as low as they'll go
As the ramifications of the coronavirus and its economic impact continue to unfold, U.S. yields are likely to remain constrained in a lower range after their dramatic move lower in the past four weeks. Indeed, prospects for a near-term acceleration in global growth that we were expecting as the new year got underway have faded, suggesting global central banks may be inclined to ease further. Despite the U.S. economy’s favorable fundamentals and some modest upside for inflation, the Fed could ease if international challenges worsen, the recent spread of the virus continues and steep declines in stock prices extend further.
The virus and measures to contain it are in the driver's seat, acting as an exogenous shock to economic activity and macro performance. The virus global propagation outside of China has intensified sharply. The playbook of governments in many countries is clear: shut down activities (close schools, cancel travel, enact quarantines, etc.) and impose “social distancing.” Such measures to contain a highly contagious virus may or may not work, but such measures will extract economic costs in terms of slower growth and rising prospects of recession in some (or many) countries. Fiscal and monetary stimulus is on the way in many economies. Such stimulus is likely to cushion the economic blows, but will not fully reverse them. The dislocation also may cause some bottlenecks and inflation to rise, but that effect likely would be more fleeting than the growth shock.
Just a few days ago, I commented on how the implied degree of Fed easing in the bond market seems overdone (currently, futures are pricing in two quarter-point cuts this year). It still does. But the range of uncertainty surrounding the economic outcomes is wide and asymmetric toward the downside. A Fed that just last year acted for “insurance” seems likely to do so again, and the amount of easing remains unclear. In the meantime, liquidation of positions in volatile and jittery markets seems likely to persist, holding the potential to drive U.S. Treasury yields even lower from their current record lows. Meanwhile, any positive news on virus containment likely will cause some retracement higher. On net, the risk to rates surprisingly has become symmetric around these much lower levels, prompting our fixed-income team to adopt a neutral duration stance until these opaque risks become clearer.