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The global economy faces significant headwinds associated with COVID-19. We expect the U.S. economy to fall into a recession in the first half of the year. Falling global demand will likely keep a lid on inflation and interest rates, though we expect both to rise as economic conditions eventually improve. Extreme bond market illiquidity should subside gradually due in large part to aggressive monetary stimulus.
Monetary stimulus to help stabilize bond markets – The Federal Reserve took aggressive action to inject liquidity into the bond market and facilitate the flow of low-cost credit. In addition to lowering the federal funds rate to near zero, the Fed pledged to buy unlimited Treasuries across maturities, resumed purchases of mortgage securities and began buying investment grade corporate bonds and exchange-traded funds (ETFs) and short-term municipal fixed instruments. The Fed also increased access to funds for businesses under pressure to meet short-term operating expenses and provided a backstop for money market funds.
Liquidity challenges continue – In Q1, panic sellers sold off liquid assets, including usual safe havens. During the height of the market selloff, 10-year Treasury yields fell to a record low, and three-month Treasury bills edged below zero for the first time since 2015, as shown in the chart. Abnormal price distortions caused by stressed market conditions in municipal and corporate bonds should continue to ease as large infusions of monetary stimulus improve market function, while rock-bottom interest rates should help springboard the eventual recovery.
Rates likely to stay even lower for even longer – We think the current environment will keep Treasury yields at very low levels. Low inflation gives the Fed latitude to keep rates near zero until the economy improves.
Bond markets’ role as a ballast during market turbulence will be a key focus this year. Bonds tend to move in different directions from stocks over time and can provide an important diversification benefit. We recommend owning a variety of equities and bonds of varying maturities, including investment grade corporate and high-yield bonds as appropriate, to help cushion market swings.
Diversification does not ensure a profit or protect against loss in declining markets.
Investing in equities involves risks. The value of your shares will fluctuate, and you may lose principal. Investors should understand the risks of bond investing, including credit and market risk. Bond investments are subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease; investors may lose principal if sold prior to maturity.
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