Coronavirus emergency: Fed cuts rates, but markets expect more

Does the Fed expect a rapid deterioration of financial or economic conditions with spillover to the credit market?

As the Fed reiterated in its statement, the fundamentals of the US economy remain strong, but the central bank is worried about the evolving risks to the longer-term US economic outlook. This is partly due to the reaction to the spread of the Coronavirus around the world and to a lesser extent in the US. The Fed and the G7 are both concerned about the tightening of financial conditions emerging from the falling stock market, widening credit spreads and a weaker US Dollar. The Fed minutes refer to some member’s support of “financial stability escape clauses”, which may have triggered the emergency cut to temper market volatility and liquidity concerns.

Has the Fed rate cut changed your fixed income convictions and do you see opportunities to benefit from this move?

Our convictions are unchanged. We continue to prefer corporate credit and securitised bonds, especially as they reflect exposure to residential housing and the consumer. Agency mortgage backed security prices have softened to reflect higher prepayment risk with the sharp decline in US treasury yields. We remain cautious on US duration. We are contemplating further weakness in the USD due to potential interest rate convergence as the Fed eases, and with the increased likelihood of broad-based fiscal stimulus.

As active managers, we are identifying opportunities to benefit from current market conditions. Volatility in corporate credit has disproportionately widened the spreads in certain sectors and securities. There are opportunities in companies that remain fundamentally strong, with reasonable leverage and liquidity, strong cash flow, and which are not dependent on high capital expenditures. There is also an active new issue market, creating opportunities in companies in which we have high conviction. Sectors and securities that have lagged the widening are less attractive and can be targets to reduce exposure. Given high levels of uncertainty, investors should be patient and selective in exploiting entry points in corporate credit.

European Central Bank:

• Mentioning risks for both the macro and financial outlook, the ECB joined other major central banks in opening the door for more accommodation to come, despite limited margins of maneuver for further rates cuts.
• “Appropriate and targeted measures” cited by the ECB point to more efforts in support of liquidity and financial conditions: we expect the ECB to focus on leeway offered by more QE and by renewed measures on long term refinancing operations.
• A further rate cut remains an option, but it looks less effective than other measures in terms of monetary stimulus transmission.

Bank of Japan:

• In line with the statements released by other major central banks, the BoJ communicated that it will provide ample liquidity to ensure stability in financial markets, through appropriate market operations and asset purchases.
• Therefore, we expect more liquidity to be injected into the system, and we keep our previous expectations for 10 bp rate cut over the next 12 months.
• At the same time, we expect the central bank to keep focusing on the slope of the curve, in order to maintain the effectiveness of monetary stimulus.

Bank of England:

• Within a broad turn to a more accommodative stance of G4 central banks, the Bank of England stated that it’s working “to ensure all necessary steps are taken to protect financial and monetary stability.”
• Within a sort of synchronised global easier policy scenario, therefore, markets turned to imply two rate cuts by the BoE in the next 12 months, the first of which is expected in the short term.
• In our view, the probability of a rate cut has materially increased, despite the BoE’s move to keep rates on hold in recent meetings.