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This week’s volatility has been dramatic. Increased fears regarding the spread of COVID-19 have been reflected with stocks selling off and the flight to quality leading to dramatically lower treasury rates. The 10 year Treasury yield has fallen from 1.60 early in the month to touch 1.25 this morning. In the short end, t-bill rates remained relatively stable, reflecting the expectation for any changes in FED monetary policy to be gradual in the coming months biased toward modest easing. That changed dramatically this morning. The market has begun to price in more aggressive movement by the FED, with expectations now for two and possibly three 25 basis point cuts by June. There was speculation this morning that the central bank might even act preemptively and cut 25 basis points before their FOMC meeting on March 18. 3 month t-bills dropped about 9 basis points to a discount rate of 1.39 and the 6 month bill dropped about 12 basis points to 1.27. The market has stabilized a bit and those rates bumped up a couple of basis points since, but the market remains very anxious.
In thinking about where Treasury yields are heading, there are 2 scenarios the street is considering at this point in time.
A best-case scenario centers on: the disease stops spreading in China, Chinese production recovers quickly, the global spread of the disease slows, countries with a significant number of cases, Singapore, Italy, Hong Kong, Japan, etc., stop the spread and other countries keep the contagion to a minimum. In this case US GDP loses approximalty 0.75% over two quarters. Q2 likely worse due to lag between parts not shipped from China affecting production here. If the economy stalls for a month or two, it can easily restart. As for the Fed, best-case scenario would be Fed funds cuts of 50-75bp likely April-end of 2nd qtr (April – June)
A bad-case scenario adds significant lost output in other countries aside from China Chinese production does not recover until the second quarter. The global supply chain disruption is severe and a global recession, appears to be the likely result. In this case: The Fed comes in and cuts Fed funds to 0.00-.25bps band keeping it there through 2020 into 2021.
Bottom line: The possible outcomes, therefore, range from mild global recession and severe US slowdown To severe global recession with a moderate US recession. In both cases, Fed rate cuts are appropriate. Because the US economic impact is likely to lag even in the best-case scenario, the low in market rates is likely yet to be seen.
