S&P 500 2972 +0.6% for the week 10-year Treasury yield 0.71%
Stock market volatility continued last week as bond yields plunged to record lows. Stocks initially bounced higher from the extremely oversold condition they had reached at the end of February, but gave back their gains late in the week. Many companies are expected to cut guidance in the weeks ahead, and uncertainty remains high regarding the virus and its impact on the economy.
On Tuesday, March 3rd, the Fed announced an emergency 50 basis point interest rate cut, bringing the fed funds rate down from 1.50% – 1.75% to a new range of 1.00% – 1.25%, and stating that the virus poses an evolving risk to economic activity. Futures markets show that investors expect an additional cut at the Fed’s next meeting on March 18th, which would bring the rate down by another 50 basis points to a range of 0.50% – 0.75%. Other central banks around the world are also cutting rates.
The move in U.S. Treasury bonds has been dramatic, as the ten year bond yield has fallen to a record low of 0.71%, below the current fed funds rate, and is likely to go lower. The move in bonds can be attributed to a global flight to safety, the shock to global growth from the virus, and central bank rate cuts. Despite the strength of the U.S. economy, inflation is very low, and in fact there is growing concern about deflation.
Economic data for February was very strong, as the ADP report showed a gain of 183,000 jobs, the ISM services index rose to 57.3 from 55.5 in January, and nonfarm payrolls rose by 273,000, far higher than consensus estimates. However, despite this powerful economic data, the February reports were viewed as looking in the rear-view mirror, and investors are waiting for data for March and April, when the impact of the virus on the economy should be more evident.
Political developments last week were viewed as generally bullish, as most Democratic candidates dropped out of the race and endorsed Joe Biden, implying a lower chance that Bernie Sanders will become the Democratic nominee.
As we write these comments on Sunday, March 8th, oil prices are down sharply on reports that Saudi Arabia is planning to increase production. The resulting drop in oil prices could drive many U.S. shale producers to bankruptcy, and could have negative implications for the high yield bond market and banks that have exposure to the energy sector. The following chart provides a perspective on oil prices, showing that they still have more downside risk, despite being very oversold already.
Figure 1 Perspective on oil prices
In conclusion, the bond market has become very overbought. While bond prices could go even higher, it would be prudent to prune positions in long-term bonds in order to take advantage of their overbought condition, or to place trailing stops on some long-term bond positions, in order to take advantage of the current uptrend but lock in gains when prices turn down.
The stock market is oversold but volatility remains very high. From a long-term standpoint, the current selloff will likely turn out to be a buying opportunity, but from a short-term perspective, there is more downside risk.
For now we would wait to do any aggressive buying in stocks until there is more evidence that a bottom is in place. This may not happen until there are signs that the virus has peaked or is under control, and earnings estimates stop coming down. Another indication will be when stocks go up on bad news.
One valuable tactic that could be used to take advantage of panic selling that may still unfold is to place buy limit orders on high quality stocks at prices that seem too low. For example, Microsoft (MSFT) has fallen from its recent high of almost $190 to about $160. If we place a series of buy limit orders in the $130 – $140 range, we have the potential to get into a high quality stock at an attractive price.