Financial markets recovered in the second quarter despite predictions for a historic plunge in U.S. Gross Domestic Product (GDP). Investors took confidence in the Federal Reserve’s (Fed) robust response to the economic and market dislocation caused by COVID-19 and rolling economic shutdowns. Fiscal stimulus, primarily in form of the Coronavirus Aid, Relief and Economic Security Act (CARES), provided strong support for consumer income levels as unemployment rates soared.
Economic Activity – Second quarter U.S. GDP is expected to fall in the area of 35% on an annualized quarter-over-quarter basis, as activity collapsed from the economic shutdowns implemented to combat the spread of COVID-19. Despite the sharp decline in growth, employment conditions improved deeper in the quarter as portions of the country opened for business. After a disastrous April loss of 20.787 million jobs, Non-farm Payrolls grew 2.699 million in May and 4.800 million in June with both numbers beating expectations by a wide margin. After peaking at 14.7% in April, the U-3 U.S. Unemployment Rate fell to 11.1% in June. Initial Jobless Claims declined fourteen straight weeks after peaking at 6.867 million for the week ending March 24th. Unfortunately, the July 3rd Claims print was a stubbornly high 1.314 million, and for context, the average reading in February was 214,000 which was close to 50-year lows. Both ISM Manufacturing and ISM Non-Manufacturing have shown signs of recovery. The June manufacturing reading rose to 52.6 from a low of 41.5 in April, while the service reading rose to 57.1 from 41.8. It is important to note that while a reading above 50 indicates sector expansion, the information value may be diminished when businesses are building off a low base like the one seen in April. Various inflation measures remain visibly below the Fed’s 2% target rate, giving the Fed ample room to supply stimulus with little worry over sparking inflation at this point. While analyst estimates point to robust growth in the second half of 2020, realizing a durable expansion is threatened by additional rounds of economic shutdowns as the number of positive COVID-19 tests rise in various parts of the country.
Monetary Policy – The Fed has continued to provide broad support for the smooth functioning of financial markets through low rates, asset purchases and targeted credit facilities. The Fed’s policy reaction function appears to be asymmetric, with economic and / or financial market declines met with a vigorous policy response while asset price appreciation and strong growth are allowed to run.
Broad Fed Policy Initiatives
Policy Rates – The Fed has indicated the current federal funds target range of 0.0% – 0.25% will remain in place at least through 2022.
Asset Purchases – The Fed has committed to monthly net purchases of $80 billion in U.S. Treasury Securities and $40 billion in agency and agency mortgage-backed securities. “Securities Held Outright” on Fed’s balance sheet grew $1.326 trillion in the quarter (from $4,800.9 trillion on April 1st to $6,126.9 trillion on July 1st).
Targeted Credit Facilities – As of July 1st, the Fed had committed $12.799 billion to the Commercial Paper Funding Facility, $41.940 billion to Corporate Credit Facilities, $37.502 billion to the Main Street Lending Program and $16.081 to the Municipal Liquidity facility.
The Fed has been far more proactive implementing policy initiatives than during the Great Financial Crisis, when perceptions of Wall Street malfeasance presented moral hazard questions around monetary and fiscal responses.
Fiscal Policy – The primary fiscal response to the economic slowdown crisis was the CARES Act, which was passed into law on March 27th. CARES provided $260 billion in expanded unemployment benefits, including $600 per week in additional benefits which are set to expire on July 31st. The expanded benefits were meant to bridge the decline in employment compensation as the Unemployment Rate soared into the teens, and in some cases, analysts estimate the replacement value at well over 100% of previous wages. Government transfer payments have allowed many consumers to remain current on mortgage and other debt payments and bolster savings levels at the same time, which has in turn supported bank loan and securitized debt credit quality. There appears to be bipartisan support for another round of fiscal stimulus as the July 31st cliff approaches.
Credit Markets – A rapid decline in U.S. Treasury yields, dramatically wider credit spreads and illiquidity dominated the credit markets in March. Positive price performance from lower U.S. Treasury yields was more than offset by the negative price impact of wider spreads, particularly for lower-quality issuers and indexes. The damage to risk assets was reflected in equity levels where, peakto-trough, the S&P 500 and NASDAQ declined 34.0% and 30.1% respectively. After reaching $14.9 trillion in market value on March 9th, the Barclays Global Aggregate Negative Yielding Debt index ended the quarter at $10.6 trillion. Unlike previous periods where the decline was driven by improving global growth prospects, March’s decline was driven by increased credit concerns. One bright spot for credit conditions was the robust primary market for investmentgrade debt, which set records for monthly and quarterly issuance. A significant portion of new issuance was focused on debt with tenors of 10 years and longer, which was met with strong demand from pensions and life insurance companies in need of both duration and yield.
The 3-month to 10-year portion of the yield curve flattened by 8.1 basis points (bps), driven primarily from a small recovery in 3-month T-Bill yields after severe downward pressure on short-term rates in late March. Given the enormous amount of Fed intervention into the U.S. Treasury curve, the information value of a flatter / steeper yield curve has diminished.
ICE BofA Index definitions
*Duration estimate is as of 6/30/2020
U.S. Treasury indexes basically earned its coupon rate in the quarter with minimal room for additional price appreciation return from lower yields. Each of the ICE BofA U.S. Treasury Indexes listed saw quarter-end duration levels rise from the end of the first quarter, as the massive net issuance of Treasuries in the second quarter tended to be longer than the average duration of securities previously held in the benchmark.
ICE BofA Index definitions
Option-Adjusted Spread (OAS) measures the spread of a fixed-income instrument against the risk-free rate of return. U.S. Treasury securities generally represent the risk-free rate.
Corporate credit spreads recovered a significant portion of the widening seen in the second quarter. The primary driver for credit’s strong second-half performance was the Fed’s decisive actions to support and liquify the credit markets, including quantitative easing and the direct purchase of corporate debt and investmentgrade ETFs. OAS spreads remain wider than December 31, 2019 levels, which is reasonable given the uncertain outlook for the economy and credit markets.
ICE BofA Index definitions
*AAA-A Corporate index outperformed the Treasury index by 235.5 bps in the quarter.
AAA-A Corporate index underperformed the BBB Corporate index by 329.8 bps in the quarter.
U.S. Financials outperformed U.S. Non-Financials by 24.9 bps in the quarter.
Given the Fed’s strong support for the credit markets and a decidedly risk-on attitude of investors in the second quarter, lower-rated corporate credit handily outperformed their higher-rated counterparts. Non-financials outperformed financials by 24.9 bps and industrial companies took advantage of robust primary market conditions to issue longer-term debt to build cash balances, pay down bank lines, refinance commercial paper and pre-fund upcoming debt maturities.
The second quarter of 2020 was a continuation of the first as the invasion of COVID-19 forced market participants to speculate on the timing of potential recovery scenarios as volatile economic data was delivered. As far as investors were concerned, it was made clear by the Fed that no matter how the economic recovery evolves, policy will be easy and rates will remain at or near zero for the foreseeable future. The money market industry continued to see inflows as the second quarter began, but as funds yields declined and the panic subsided, fund balances began to decline. U.S. Treasury bill and Repo levels came off March levels - of near-zero - as government stimulus injected significant bill supply into the market,. The increased Treasury and Repo levels gave funds a modest yield boost heading into another zero-rate era.
First American Prime Obligations Funds
The volatility for prime money market continued to dissipate in the second quarter, as the Fed’s liquidity programs (MMLF, CPFF, PDCF, etc.) restored confidence in front-end liquidity while stabilizing prime fund metrics. Facing a very uncertain economic backdrop, we positioned the funds with high-quality credits supporting strong liquidity metrics based on shareholder makeup. We diligently reviewed and monitored each of our underlying credits, maintaining positions that presented minimal credit risk to the funds and its investors. Under the current market conditions, our main goal was to maintain liquidity and judiciously enhance portfolio yield based on our economic, investor cash flow, credit and interest rate outlook. We believe relative fund yields will remain elevated, making the sector an attractive short-term cash option for investors.
First American Government and Treasury Funds
As the quarter began, Treasury and government funds continued to see significant inflows as a flight to quality and yield remained prevalent. The increased treasury supply, stemming from government stimulus, resulted in higher repo and T-billyields to fund investors. Management continued to focus on securing long-term yield when it could, anticipating a low yield environment for the foreseeable future. Throughout the quarter we found opportunities in both fixed- and floating-rate investments that we believed made economic sense and felt would benefit shareholders and add value over the life of the security.
First American Retail Tax Free Obligations Fund
The swift recovery in financial markets and improved liquidity led us to consider some changes to strategy during the quarter. Fund management centered on building higher fixed-rate allocations, with a desire to lock in purchase yields for 3-12 months. We were active with extension trades throughout the quarter, but most specifically during April when the best values were attainable. Given COVID-related deterioration in credit fundamentals for many fixed-income sectors, we focused intently on security selection. Only issuers with strong balance sheets, reserves and financial flexibility were considered acceptable.
In the coming quarters, we anticipate yields will stay low as the U.S. progresses through the COVID-19 pandemic, upcoming recession and the Fed’s easy monetary policies. We anticipate the yield on non-government debt has bottomed as a result of Fed liquidity programs, tightening LIBOR levels and improved liquidity in this space. Prime money fund yields will decline as seasoned pre-pandemic purchases mature, but we believe both the institutional and retail prime obligations funds will remain attractive short-term investment options for investors seeking higher yields on cash positions while assuming minimal credit risk.
Yields in the Government-Sponsored Enterprise and Treasury space will remain influenced by Fed policy and Treasury bill / note supply. We believe the Fed will continue to provide the tools necessary to normalize the repo market, provide market liquidity and control front-end rates. Assuming no additional fed policy adjustments, we anticipate T-bill issuance to remain robust, providing the sector with an outlet for the large balances. The large amount of Treasury issuance may create some yield volatility on the short end as the supply gets absorbed. We will continue to seek opportunities – in all asset classes – that arise from market volatility based on domestic and global economic market data as well as changes in our Fed rate expectations.
U.S. Department of Treasury