Authored by Ian Lyngen of BMO Capital Markets
The second wave has arrived; or at least that is the impression one would get by glancing at the selloff in risk assets and the outperformance of 10- and 30-year Treasuries. Increasing incidence of Covid-19 cases have been reported in several states; the drop in domestic equities speaks to the reality that the pandemic is the most powerful influence on the global outlook. This observation can almost go without saying – had it not been for the Fed’s caution against extraction of too much optimism from the May employment report and the growing sense that the market had ‘moved-on’ following the recent refocus on social unrest.
With the coronavirus once again front and center, attention will undoubtedly return to the daily stats – with the emphasis on south/southwest. Needless to say, it’s a non-ideal situation for the market, the economy, and the population as a whole – even if general expectations are for a less intense return of Covid-19. In addition to the case count, the prospects for re-lockdowns will be closely scrutinized; the economic ramifications of which would likely echo the initial round, but on a smaller scale. Our base case scenario is that the unfortunate directional change in the pandemic was not unexpected; although the drop in stocks might offer a different interpretation.
Our take on the reversal of risk assets is that the optimism got ahead of itself and domestic equities came into this week vulnerable to a less than satisfactory Fed showing. The Fed wasn’t in a position to do much more in terms of deliverables (i.e. YCC, forward guidance, etc.), therefore a disappointment risk was a ‘known’ – what’s impressive is the magnitude of the downtrade in stocks. To be fair, overbought momentum has been in place since the beginning of June; heightening the odds of a correction or consolidation. We’d erred on the side of assuming an in-range correction was more probable; much to our chagrin. The 200-day moving-average at 3013 marks an important support level and is shortly followed by the handle-change <3000. The weekly close will be key from a technical perspective, as well as any dip-buying interest during the overnight session.
The rates market has benefited from an impressive flight-to-quality bid that brought 10-year yields down to 65 bp to flirt with the lowest since mid-May. A breach of 62 bp would put rates back near the lows of 54 bp and as the initial economic optimism fades, investors may once again face the question of whether or not fresh record low 10-year yields are warranted during the second wave. For the time being, we expect anything <60 bp will prove to be a selling opportunity; or if nothing else a compelling level from which to reset steepeners. Overall, the price action has the tone of a technical correction rather than a paradigm shift of the macro narrative – the next few sessions will provide greater clarity.
Thursday’s Treasury rally was backed by strong volumes as cash traded at 188% of the 10-day moving average. 5s and 10s split the designation of most active issue each taking a 30% marketshare. The front-end garnered 17% with 2s and 3s taking 9% and 8%, respectively. 7s claimed a solid 9%, 20s 2% and the long-bond was elevated going into its reopening with a 12% marketshare.