The bold extension of the Fed put

After a consolidation phase in early April, risky assets returned to an upward trend, reducing the attractiveness of high-quality government bonds. The yield on the ten-year US T-Note rebounded marginally to around 0.75%. The Federal Reserve’s potentially unlimited purchasing program is expected to keep yields under pressure as long as the economy is hampered by the Covid-19 pandemic.

Recent indicators point to dramatic job losses. Accumulated over three weeks, unemployment benefit claims exceed 16 million and the bleeding is not over. While the US job market was dry in February, the US could quickly experience an unemployment rate of 10% to 15%, or even 20% according to the darkest forecasts. The unemployment rate should therefore exceed the peaks reached in 2008, but there is reason to hope for a fairly rapid decline, in phase with the gradual relaxation of health measures which today restrict many economic activities. An unemployment rate reduced from 5% to 6% by the end of the year is realistic if the pandemic is globally overcome. We are not there yet, however, and the financial markets may be overconfident.

Certainly, the curves of infections and deaths attributed to Covid-19 have started to flatten out as a result of the health measures gradually implemented worldwide. The peak of the epidemic seems to be crossed in many countries, in Europe, and in some of the most affected American states such as New York. However, the decline is not yet pronounced enough to allow a rapid return to normal. However, a recovery in stages seems to be looming in May, as Emmanuel Macron for France has just mentioned. The robust recovery pattern seen in China may not apply to the West, where surveillance measures are less intrusive.

Supported by reassuring epidemiological trends, the rebound in risky assets is also fueled by the unbridled activism of the Federal Reserve which took a new step last Thursday. The central bank has just announced several new loan programs, for a total of 2,300 billion US dollars, for the benefit of States, cities, SMEs and even “fallen angels” companies which have just lost their rating “ investment grade ”. Very daring, the Fed has planned limited purchases of high-yield speculative bonds, notably through ETF. The support measures that initially applied to government bonds and MBSs, then to investment grade corporate bonds are thus indirectly extended to the lowest rated loans. All that is missing now is the purchase of shares to complete this famous “Fed put” which biases (for a good cause?) The perception of the risk assumed by investors.

The Fed’s creative activism confirms a fierce desire to do everything to prevent a great depression following a health crisis deemed transitory. The impact of the Fed’s gesture is significant: it has reduced the average risk premium for high-yield loans from 11% to 8%. The decline in spreads was also manifested in the investment grade segment which included a number of “fallen angels” suspended until the end of April: the average spread of this category which had peaked around 3.5% is now close to 2.4%.

Fragile projections

In Europe, interest rates in euros have recovered slightly, leading the 10-year Bund’s yield to above 0.4%. The risk premiums imposed on Italy have widened slightly to exceed 200 basis points after ten years. The meeting of the “eurogroup” has resulted in the creation of an emergency fund totaling 500 billion euros, but this device does not provide for solidarity financing through “corona – or pandemic – bonds” committing jointly euro area countries.

Projections released in the latest edition of the IMF’s “World Economic Outlook” show a contraction of 3% of world GDP in 2020, which would be the worst contraction since the Great Depression. Euro area GDP is projected to decline 7.5% in 2020, before growing 4.7% in 2021. US GDP decline is expected to reach 5.9% this year before a rebound also estimated at 4 .7% next year. These projections are fragile, but they join the relative optimism of the financial markets.

* Bank Management Profile in Geneva

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