The Underlying Bond Rally

The coronavirus remains the focus, as the market took another gut punch today (03/03/2020) right after yesterday’s historic gain. To probably no one’s surprise, the roller coaster continues. Investors are reacting to headlines on the spread of the coronavirus around the globe, now officially known as COVID-19, as well as recent mixed economic data. After a relatively calm year for the markets in 2019, it’s important to maintain perspective and stay disciplined.

The Federal Reserve (Fed) also slashed interest rates today, trimming the federal funds rate by 0.50% to a range of 1-1.25%. The market obviously responded negatively – probably because the rate cut caused more confusion than anything.

Gauging the potential economic and market impacts of all this is difficult, a fact that adds to market uncertainty. For investors and economists, the past is still the most useful guide to the future. The fact that COVID-19 is unique and has spread quickly makes it difficult to compare to past episodes.

However, even if we can’t directly compare COVID-19 to previous SARS or Ebola outbreaks, we can compare this market decline to previous ones. At the moment, the U.S. stock market has pulled back about 11% from recent peaks – a technical correction. And certainly this pullback may worsen as the virus spreads. However, it is not unusual for much worse market declines to occur each and every year before the underlying situation stabilizes. And whether it takes weeks or months, markets eventually recover.

Over the past week, however, an equally important market reaction may be in interest rates. The 10-year Treasury yield is now under 1% for the first time, plunging below its 2019 low of 1.45%. At this point, the 10-year rate has not been above 2% since summer 2019 and has not been above 3% since 2018.

A central reason for such low interest rates is that the Fed has kept its policy rates low. As coronavirus fears grow, expectations that the Fed will step in to support the economy and the market has also increased. This is referred to as the “Fed put” since it is akin to a put option contract that protects investors from downside risk.

Fortunately, low interest rates at the start of 2020 are less about the possibility of an economic recession. In fact, the other side of the coin when bond yields fall is that bond prices rise. Thus, bonds can help investors who have diversified portfolios weather this period of volatility, no matter how long it lasts.

Below are three charts that put these trends in perspective:

1. Interest rates have fallen and bonds have rallied

Interest rates have fallen due to recent global headlines. They are now below their lowest level in 2019. The flip side of lower interest rates is that rising bond prices help diversified portfolios by offsetting stock market volatility.

2. The Fed is one reason interest rates could remain lower

As I stated earlier, The Fed’s willingness to act is certainly one reason that interest rates have remained low. This was proven again today as they cut rates by 0.50%.

3. One positive outcome is that mortgage rates could remain lower as well

Lower interest rates still help some parts of the economy. The 30-year fixed mortgage rate is still extremely low. So, while the spread of coronavirus and other scary headlines may hurt investment portfolios and portfolio income in the short run, low interest rates could boost investor returns in other areas.

In an overwhelmingly negative environment, bonds are the one bright spot. Holding an appropriate allocation of bonds in a portfolio can help to offset some of the volatility from stocks and present rebalancing opportunities.

Source: Clearnomics