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When Fear Becomes Reality

| March 09, 2020

We started writing this on Friday, wanting to share a few additional bits of info on top of what we had already shared over the past couple of weeks. Thanks to a busy workload, we never were able to hit the send button – and little did we know how much would change by the time we came back to it today. We were prepared to talk more about COVID-19, not knowing that as we went about our weekend, the Saudis and Russians would fall headfirst into an all-out crude oil price war. Just when the markets seemed to be settled into corona reality, this new shoe dropped, sending uncertainty to heightened levels and equity prices tumbling. 

Wait, aren’t lower oil prices good? For us as consumers, the answer is undoubtedly yes. For airlines, the answer is yes – but will they have anyone to transport thanks to corona-related fears? For the markets, it’s a different story. When prices plummet 25%+ in one day, the worst drop since the Gulf War in 1991, the markets worry. Will this trigger defaults in the energy space? Will it lead to layoffs across these large workforces? Will it signal the onset of recession in oil-dependent countries? That is still yet to be known.

Now back to COVID-19. What more can be said, than what has already been said?

With 24/7 coverage on COVID-19 and a real-time running ticker of infections, everyone knows where this is at. And while I don’t want to beat this horse anymore, if we follow standard safety practices most of us have very low risk. If you are older or have respiratory issues or a compromised immune system, you are at higher risk (not just for COVID-19, but complications from the flu in general), and you should be ever vigilant in taking the appropriate precautions. For the rest of us, widespread closings of schools, businesses, and public places may slow the pace of spread, but we all shouldn’t wonder then why the stock market is going down and interest rates are plummeting (more on that in a minute).

What I really would like to say is make sure you are doing the prudent things to keep you, your family and those that you care about safe and healthy. If that means staying locked in your house, I get it. In fact, if you are in those circumstances, please don’t hesitate to reach out if there are ways we can tangibly support you as you hunker down until the storm passes. For the rest of you, please don’t stop what you’re doing unless you are at higher risk or pose a risk to others, and above all else, see the chart below for safety tips, brought to you by Snohomish Health District.

Let’s now get back to what’s going on in the world that we think is interesting and important. The 10-year treasury is at an all-time low this morning and likely will head lower as we get riled up into a lather. I can’t get a great up-to-the-minute chart, so I will put an arrow where we are today, currently 0.50%. In case you thought I misplaced a decimal, that is less than one-half of 1%. Historically, mortgage rates would be about 1.5% higher than a 10-year treasury, today those rates are around 3.25% (about 1.25% above what we would expect). Why? My guess is one of two things…either mortgage companies think this is a short-term phenomenon or it is fear manifesting itself through lack of fluid lending. Translated, this means banks are resisting lending at traditional spreads because they need to have extra liquidity, or the volatility of hedging makes the costs higher. I’m going to say it’s a bit of both, but more on the side of the hedging costs. Just a guess on my part (I haven’t seen any data published about this yet).

Take a look at the AAII survey that I have shown before. It’s not as bearish (meaning bullish) as you would expect. Remember, this is a contrarian indicator and when it shows up as very bearish, it’s actually bullish. I know, confusing, right? (it’s basically saying the crowd is usually wrong!). For a real bottom to be in, we would expect that number to be much worse.

High yield bond spreads have blown out (meaning the difference in yield between lower-quality bonds and government bonds has widened). That’s a good thing. If we’re looking for a bottom to the market, we need to look for extremes. We’re definitely not at extremes in this, but we’re getting there.

This is just incredible. After a surprise interest rate cut of ½% (although yours truly mentioned it in this blog), FED Funds futures are looking for a cut of around 1% in short-term rates AGAIN by the next meeting which is March 18th. That would a cut in short-term rates by a percent and a half in just a couple weeks. Something you don’t see every day.

The FED is either already WAY behind the curve (the economy is in recession already) or they are pounding that screw into the wood with pure brute force (meaning they can’t fix this problem with more money). As I have mentioned so many times over the last 20 years, the FED seems to drive the car from one ditch to the next, or to use someone else’s analogy, the FED is a bug in search of a window.  We are quickly going to ZIRP (Zero Interest Rate Policy). On one hand, this reflects a very negative view of where the world is headed economically, on the other hand it is a stimulus for most consumers. Lower mortgage rates, lower loans all the way around with the hopes that that stimulates business activity. Of course, those businesses need to be going concerns and that’s the big concern, especially the oil drillers, as we alluded to earlier.

On a brighter note, not that anyone cares (because it’s last month’s news), the Labor Department reported that 273,000 jobs were added last month and the unemployment rate fell to 3.5%, matching the level from last year and all the way back to 1969. Oh, that was a good year!!!

We will be cautious as we have been and look for opportunities. From my vantage point, it looks like the only thing that can really kill the market is our fear. Didn’t somebody once say, ‘The only thing we have to fear, is fear itself?’ Well, it doesn’t appear that way now. We have COVID-19 to fear, and now we can worry about an international price war on oil. As always, our model is working, we have gotten more conservative over the last several months and will continue if warranted. Be safe out there work on that elbow bump greeting.