A Macro Thesis for Higher Rates Due to the Coronavirus
This headline may seem crazy since bonds are the only asset that have gone up recently. Stocks, gold, silver, oil, bitcoin, and the dollar are all down. In other words, even your dollars are losing value on a relative-basis due to currency flows, so hopefully, you own some 10-Year Treasuries paying a whopping 0.68%.
The decline in all of the markets listed above, with the exception of the dollar, is the result of decreased demand. Due to coronavirus fears, people's economic behavior will change. They will likely travel less, eat out less, and attend less public events. The market discounts future events, so money is moving around accordingly.
As we've explained in our Mercator Letters and previous blog posts, we are, and have been, in a deflationary economic environment. Bonds tend to be a top-performer when deflation is prevalent, and recent market behavior provides an excellent example.
But our headline surrounding higher rates due to the coronavirus doesn't come from demand, but rather, a potential supply-shock. Traditional supply chains have already suffered as a result of government-imposed shut downs and quarantines. While such measures are necessary in a time like this, the fact of the matter is, there are economic consequences to it, whether we like it or not.
There are a couple points here worth making; the logic is as follows:
1. If businesses are not able to purchase inputs to create their products, they will look elsewhere for alternative suppliers, and would even be willing to pay more for those inputs, just so they can stay operational. The increased cost of inputs will be passed down to the consumer, who will be forced to pay higher prices. If businesses can't find alternative suppliers, they'd probably just shut down. Those that do remain open would then have to increase production, which, on such short-notice, means higher costs, and would translate to higher prices. Higher prices means higher inflation readings, and this means higher interest rates.
2. The U.S. Dollar continues to struggle. Full disclosure, we aren't highly confident on this point, as eventually, the world will want to seek refuge again in dollars and dollar-denominated assets (Treasuries have still done well). Nonetheless, the dollar has been declining in recent weeks, and this usually has an inflationary effect. But we haven't seen this unfold yet, as commodity prices plunged in recent weeks, but that could change, and if it does, it too would buoy inflation expectations.
Now, for some good news: The yield curve is steepening. Remember that with the exception of Quantitative Easing, rates on the longer-end of the yield curve are more susceptible to free-market forces versus the short-end. With the Federal Reserve looking like they're going to reduce short-term rates to zero next week, we are seeing the yield curve steepen, and even reach its highest level in months. A steepening yield curve is a signal of confidence from the bond market, which is 5x larger than the stock market, and where a lot of the "smart money" plays.
So maybe, the world isn't ending after all? At least the bond market doesn't seem to believe it. Furthermore, it would be hard to argue against the notion that we are in a hysterical environment at the moment. These are exactly the type of environments where market bottoms are made. We aren't fans of catching falling knives, but with the end of flu-season right around the corner, perhaps we will return to normal in just a few weeks time.