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Market Voice: Bond markets react to COVID-19

Ron Leven
Ron Leven
Professor of Economics at Duke University

The extreme economic contraction triggered by COVID-19 has sparked across-the-board asset liquidation. April’s Market Voice looks at how this extreme market environment is affecting credit conditions and the ability of the bond market to snap back when the crisis fades.


  1. The second half of March saw an almost unprecedented simultaneous selloff of bonds, stocks and commodities.
  2. The Fed’s massive liquidity injection seems to be normalizing the market environment though and limiting the damage to credit spreads.
  3. In contrast to the Financial Crisis of a decade ago, money-center banks are only mildly stressed, which is the key to seeing a rapid rebound once COVID-19 is under control.

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The bond market in a crisis

Traditionally bonds – and especially Treasury Bonds – are the beneficiaries of bad times for equities, both because they are generally deemed as less risky and diving equity prices are usually a harbinger of lower interest rates.

But March saw an almost unprecedented simultaneous selloff of equities and bonds.

The circled area in Figure 1 highlights the period when equity prices (SPX) were falling and U.S. 10Y Treasury rates were rising – i.e. bond prices were also falling.

Gold is also a market that commonly thrives during adverse financial environments but, as shown, gold prices also sunk during this period.

It seems the onset of the COVID-19 crisis sparked demand for cash balances so strong that selling occurred across all major assets, dissolving the usual correlation between equities and the bond market(s).

Figure 1: The market was selling everything (weekly closes)

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There are reasons why the market was so hungry for cash that it experienced the unusual simultaneous selling of stocks and bonds, as well as precious metals.

Businesses anticipating that the COVID-19 forced shutdowns would hurt revenue flows and may have been building cash balances to temporarily cover fixed expenses.

Also, the usual bond buying when stocks sell off may have been inhibited by the prospects of the huge supply that will be forthcoming from the government’s need to finance the recently passed $2 trillion fiscal support package.

Figure 2: US 2Y and 10Y Swap Spreads vs UST and UST 10Y Rate Outright (weekly closes)

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Both the need for cash and concerns about bond supply may also explain the temporary move of swap spreads into deep negative territory.

In principal, U.S. Treasuries are the benchmark for default-free lending so should always trade at a lower rate than swaps.

We discussed in last October’s Market Voice how a dip into negative territory probably reflected an anticipated bulge in supply together with US dollar reserve reductions – which results in U.S. Treasury selling – by foreign central banks.

The recent strength of the dollar has further incentivized central banks to cut dollar holdings so with the flood of bond supply set to hit the market, it is consistent that the spread went deeper into negative territory to a record low -22 basis points.

There are clearly signs that the economic disruptions of COVID-19 are badly impacting credit markets, bond spreads are widening out and mortgage markets are also under pressure.

But we believe that the swap market shows a more positive picture. The spread has moved back towards positive this past week, which we interpret as a normalization of the relation between swaps and Treasury rates.

The spread would need to move more than 5 to 10 basis points above zero to begin implying serious concerns building on bank solvency.

Figure 3: Monetary conditions (weekly closes)

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The Fed comes to the rescue

Last month, we noted that negative news on COVID-19 was shrugged off by the market until the Fed – perhaps unintentionally – shrank their balance sheet tightening monetary conditions.

While the balance sheet shrinkage did not itself cause the downturn, it may have made the market more sensitive to the COVID-19 negative news.

In any event, the Fed has more than reversed the earlier shrinkage and, as shown above, their balance sheet expansion closely matches what they achieved in the wake of the 2008 financial crisis selloff.

As in that episode they are also providing monetary support by cutting the Fed funds rate.

However, it is notable that the historical alignment between Fed funds and the balance sheet suggest that rates should be roughly 100 basis points lower, but the zero boundary is limiting the degree of support the Fed can provide to the market.

To date, the Fed has not expressed intent to follow the ECB and BoJ and take Fed funds into negative territory.

The zero bound on Fed funds may also explain the divergence between the o/n repo rate and 3M Libor shown in Figure 4.

Figure 4: The USD Overnight Repo and 3M LIBOR Rates

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Libor normally trades at roughly a 10 to 20 basis point spread over repo but it is now trading with over a percentage point spread.

The spread behavior is like the pattern when the Fed was cutting rates in response to the 2008 market decline.

Concerns about risks of bank failure was a primary driver of spread widening in 2008, but we think this is currently not as important.

As noted above, swap spreads, while widening, are only marginally above zero.

Moreover, Figure 5 shows that the rates implied in the EURUSD forwards remain consistent with Libor spreads which was not the case during the ’08 selloff.

We believe the zero boundary is a bigger factor in the spread, but we think it is important to monitor the currency forwards for signs of broader credit stress in the banks.

Figure 5: 1Y USD vs EUR LIBOR Spread and EURUSD 1Y Forward Premium

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The bottom line: Bond markets are now firmer

The economic upheaval from COVID-19 created a massive rush to build cash balances sparking an unprecedented simultaneous selloff in stocks, bonds and commodities.

While stock prices remain under pressure, the cross-market selling has abated – bonds, in particular, are firmer – which is likely a reflection of the massive liquidity added into the bond market by the Fed.

There are also still serious strains in credit markets, but we see the stability of swap markets and foreign exchange forwards as an indicator that the balance sheets of major money-center banks are still sound.

An intact banking system will be critical for a healthy economic rebound once the COVID-19 threat subsides.

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