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During the equity market’s ascent to all-time highs in early February, many had dismissed the idea that the COVID-19 drama would drag on for an extended period. This was based on the relatively quick containment of equity losses surrounding past viral outbreaks like SARS, MERS, Avian Influenza and Ebola. Many Federal Reserve officials were among those hoping for COVID-19 to be contained by mid-March. Here’s a fun fact, the S&P’s max drawdown from February’s closing highs now exceeds the drawdowns witnessed during the corrections associated with all of the aforementioned viral outbreaks.
With 10s now sitting within reach the psychologically-significant 1.0% area and registering the most overbought reading since September ’98, many portfolio managers are probably feeling quite tempted to reduce duration as we approach quarter end. As a volatility and sentiment guy, I feel comfortable in suggesting that there will be a better opportunity to do so. Not just because not knowing how long into the 2nd or even 3rd quarter this nightmare will last breeds uncertainty, but because Treasury yields are still gapping lower without any real volume-related proof of two-way flows.
Tracking expectations with regard to the calendar, then, is a focus for the remainder of Q1. After Chairman Powel opened the door to a rate cut at the Fed’s March 17-18 meeting by pledging to “act appropriately” in comments made this past Friday, market participants are closely monitoring for any signs that a risk-on rebound has begun.
To those who think Friday’s equity market rebound from the S&P 500's late 2019 lows is signaling that such a rebound has begun, I would suggest limiting your upside expectations for the following reasons: First, the level of equity put protection currently being sought seems far too low to produce a major price bottom. Second, with credit spreads now showing 3rd wave characteristics as long-term smoothing is just starting to rotate wider, technically, the mechanics are in place for widening to continue from here.
With this in mind, I think the anomalous extension targets presented on today’s chart for benchmark 10-year yield are very much realistic. Specifically, not only are discretionary methods arguing that duration should not be shed until the 10-Yr yield enters a zone of 93bp to 50bps but our statistically-based volatility measures also lend credence to this idea.