The global escalation of the COVID-19 crisis has created a perfect storm for the markets. The S&P index has declined 35% from it’s all time high of 3,400 since February of this year, while the EuroStoxx 50 has dropped 40% over the same period. The panic in the Equity market is a reflection of the risk-off attitude where the market is looking for “Safe Havens” such as US treasuries. This buying accelerated after the Fed announced that it will be purchasing an unlimited amount of assets. The US 10-year notes are cur-rently yielding 0.766% from a recent 0.687% low. Surprisingly enough, gold did not rally as it has during in previous economic downturns, but instead has had a sharp correction from USD 1,700 per ounce in February this year back to USD 1,400 last week and is currently trading at 1583.
What are the central banks doing about COVID-19?

Bank of England

We have seen central banks cutting rates and activating QE programs in an attempt to counter the negative impact of COVID-19 on their domestic econo-mies. The BoE has cut rates twice from 0.75% down to 0.1% and reinstated QE by putting in place a purchase bond program of GBP 230 Billion. The second wave of stimulus announced last week was triggered by the BoE’s forecast of a contraction of GDP of 2.7% instead of the 1% growth initially expected. The BoE made a joint statement alongside the UK banks where Andrew Bailey tried to fill the market with confidence by assuring that UK banks are in a strong position to support the adverse economic implications of the corona-virus.

US Federal Reserve
At the same time, the Fed announced an unlimited QE program and cut rates to zero. In this new version of QE, the Fed will be purchasing corporate bonds for the first time, limited to investment grade securities in both primary and secondary markets. The aim of this change of strategy is to tackle the liquidity turmoil which has intensified during the past weeks.

European Central Bank
The ECB fuelled the European market after announcing an aggressive plan to expand its asset purchases by EUR 750 Billion over the next nine months. The European bond market recovered after the announcement, reducing financ-ing costs of governments like Italy, Greece, Germany and France. Christine Laggard focused on providing confidence to the market by tweeting that “There are no limits to our commitment to the eurozone”.

Bank of Canada
Following the same path, the Bank of Canada announced their plan purchase corporate and municipal debt. The government amended the bank’s charter by giving the BoC the power to buy corporate and municipal debt as long as it is “addressing a situation of financial system stress that could have material macroeconomic consequences”. In addition, the BoC has cut rates twice from 1.8% to 0.75% in a window of two weeks. We expect by the latest gov-ernment amendment to introduce an asset purchasing program to reverse the effect of the COVID-19 crisis which the latest BoC forecast estimates will reduce economic output by between 10-24%.

Shifts in Market Pricing Present Challenges for Some, and Opportunities for Others
Due to the stimulus programs that central banks have put in place, interest rate differentials between most coun-tries have shrunk, and spot rates have moved a lot in favour of the US Dollar. Some pairs have moved to levels nev-er seen previously. Whilst this has made hedging more expensive (or provides less of a forward point pick-up), for others the opposite is true.

Cost of Hedging
We can divide the cost of hedging into two main components: Inter-est rate differential and transac-tion costs. For any Forward based strategy, interest rate differen-tials result in either positive or negative carry. The table below compares carry today with carry 3 months ago. These are presented from the perspective of a non-USD fund (or a GBP fund in the case of GBPEUR).

GBP and EUR denominated funds have had a significant reduction in such costs, especially in longer tenors. However, while the carry impact has significantly improved, the transaction cost of trade execution has increased quite a lot, driven by the low levels of market liquidity. Banks are averse to taking on market risk due to elevated levels of volatility, and spreads have increased significantly as a result.

We’ve also seen large moves in spot prices, with USD and EUR appreciating against most currencies. A good measure of currency strength is Purchase Power Parity which helps to benchmark current levels against a “fair price”, derived from inflationary measures.

The PPP valuation summary shows that
current spot levels present an opportunity
for GBP, EUR and CAD denominated funds
to lock in current rates against the USD.
We want to emphasize that PPP metrics
are used in very long-term horizon strategies
as history shows that FX rates tend to
converge to their fair valuation in the long
term. Carry analysis also suggests that engaging
into longer strategies optimizes the
cost of hedging as we have previously
pointed out.

While PPP indicates that these good levels to execute long dated strategies, it is important to note that market liquidity will result in high frictional costs. At Validus we are happy to provide guidance on how we can achieve best execution through this challenging market.