In the past two weeks, the traditional negative correlation between equities and government bonds has broken down. This has resulted in both asset classes generating negative returns and has undermined the benefits of government bonds as a stabilizer for investment portfolios.

This is partly driven by the surge in demand for liquidity created by selling pressures. Investors have been selling assets that have suffered losses in this downturn and assets that are considered to enjoy better liquidity. U.S. Treasuries are an obvious candidate, and the pressures to sell where not met with a demand to buy in the private sector has created a liquidity squeeze and spike in yields. This was particularly obvious in some of the “off-the-run” Treasuries. Corporate bonds have also seen their corporate credit spreads widen due to worries over the rise in defaults. The U.S. dollar has also strengthened given strong demand for U.S. dollar liquidity from investors around the world.

Hence, one of the Federal Reserve’s (Fed’s) policy objectives in the past two weeks has been to restore normality in these markets by providing as much liquidity as possible, stepping in to be a ‘buyer of last resort’. The latest policy announcement includes removing the ceiling for the purchase of Treasuries and mortgage-backed securities (MBS), also known as Quantitative Easing (QE) Infinity, and adding agency commercial MBS to the list. The Fed also created two new credit facilities to support new bonds and loan issuance and to provide liquidity in the secondary corporate bond market.

The Fed will also re-introduce Term Asset-Backed Securities Loan Facility (TALF), providing loans against eligible asset-backed security collateral, including student loans, credit card loans and auto loans. Exhibit 1 on the next page shows some of the measures announced since early March, compared with equivalent measures implemented during the global financial crisis. The Fed has largely brought back liquidity measures introduced in 2008/2009 and expanded the coverage of some of these programs.

U.S. Treasury yields have fallen on the back of aggressive asset purchases by the Fed. However, market liquidity continues to be tight, as illustrated by the wide spread between bid-offer spreads in the Treasury market, reflecting the larger than usual gap between buyers and sellers. If these spreads do not narrow, the Fed may be forced to pump out more liquidity via the current tools, or to become more creative in offering direct liquidity support to a broader range of companies. Some of these creative solutions may require approval by Congress. 

EXHIBIT 1: United States Federal reserve policy (2020 and 2008)

Source: J.P. Morgan Asset Management.
Data reflect most recently available as of 23/03/20.

Investment implications

Market liquidity in the Treasury market could remain pressured in the near term as the Fed tries to restore a normal functioning market and increase stability. There is no doubt that the Fed is acting aggressively to restore market confidence. Some of these solutions may take time, needing to go through some policy and political debates. Nonetheless, the risk to government bond yields in the medium to long term remains on the downside given the aggressive monetary easing by central banks around the world just in the month of March alone. The Fed is not the only central bank to opt for a zero interest rate policy and another round of quantitative easing. The European Central Bank has announced an additional EUR 120billion of asset purchases, and a further EUR 750billion under its emergency pandemic asset purchase program. The Bank of England and the Reserve Bank of Australia have cut their policy rates to their respective record lows. Once the liquidity strain is behind us, the hunt for yield is likely to start again.

This implies developed market government bonds still have a role to play in a defensive portfolio during this period of pandemic escalation. Reduced liquidity strains should also help to curb U.S. dollar strength and provide some relief to emerging market and Asian assets. 

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