Boston - As a result of the pandemic crisis, the US gross domestic product (GDP) peak-to-trough drop will probably end up being around 11%. That compares to around a 4% contraction in the financial crisis. While risk markets have broadly recovered from their March 2020 declines, we believe it's increasingly apparent that the US economy is likely going to take considerable time to recover.
Fed unemployment projections and yield curve expectations
The Fed is projecting the US will end the year at around 10% unemployment. While that is a huge number, it's even more concerning when you look at the underemployment rate — the percentage of people who are working part-time but want to be working full-time. Today, that stands around 18%. Overall, the US economy is service-driven — the area that's been hit hardest through this crisis and where there's still a lot of uncertainty around how quickly things can recover.
The US Federal Reserve is projecting no rate hikes through the end of 2022. So clearly, the Fed doesn't think this recovery will be V-shaped. Not only don't we expect the Fed to hike rates for some time, but we also don't expect them to cut rates into negative territory. As a result, the short end of the curve is likely going to remain relatively fixed in place for a while.
When rates are this low, look for wider spreads
Rates are low pretty much anywhere you look, especially in safe, cash-like assets. Looking at the 20 largest money market funds, for example, they are on average yielding less than 20 basis points today, which is down more than 200 basis points over the last few years.
Spreads in the agency mortgage-backed securities (MBS) market remain wide. Today, they are at 123 basis points over Treasurys, versus around 75 basis points for their longer-term averages. One reason is the record supply, mainly due to refinancing, as well as the home selling season, which was delayed because of the pandemic. We expect those technicals will eventually reverse and work in our favor, especially as the Fed's buying continues. Year to date, the Fed has purchased more than $800 billion in agency MBS.
Bottom line: Going forward, we think that the short duration government income/agency MBS space could offer opportunities. Some investors may benefit from upgrading the credit quality and yield of their fixed income portfolios by moving out of ultrashort funds. Other investors have an opportunity to take that first baby step on the risk spectrum from their money market funds — where they are likely yielding less than 20 basis points — to potentially earn substantially more income.