Investors face a dilemma in their reading of capital markets. Should they be guided by the rising cases of coronavirus in the U.S. and minimize risk, or do they take on risk in the expectation that the Federal Reserve will be there to support markets once more.
The resultant uncertainty can be seen in the VIX, which measures investor expectations for volatility on the S&P 500 index. The so-called Fear Index remains at historically elevated levels even after falling significantly from the record highs it reached at the beginning of the pandemic's arrival on U.S. shores in March.
The VIX reached a record 82.69 on March 16 but was back down to 33.29 by April 27 as the combined forces of the U.S. Treasury and Federal Reserve committed trillions of dollars to support the economy.
That support has continued to ease other key measurements of risk in financial markets, yet the VIX has remained stubbornly high. At 33.84 at the close of June 24, it remains more than double the 16.6 average from the first two months of the year.
"While equity volatility should normalise further with a better macro backdrop, it is likely to remain elevated compared with long-run history in the coming months," Goldman Sachs strategists led by Christian Mueller-Glissmann wrote in a research report.
The number of coronavirus cases rose by over 36,000 on June 23 causing the S&P 500 to drop 2.6% on June 24, and with the June 24 infection rate rising by a further 38,386 — the second-highest daily increase — more turbulence seems likely.
Still, the benchmark U.S. equity index has rallied more than 36% since touching this year's low on March 23 and is less than 10% below the record high it reached on Feb. 19.
"Over the past three months, markets have struggled to reconcile the sharpest ever quarter-over-quarter decline in economic activity with the announcement of the largest economic stimulus packages in history," wrote Frederique Carrier, head of investment strategy at RBC Wealth Management. "The result has been high volatility, and we believe this will likely continue."
High quality credit spreads have been relatively unaffected by the recent increase in U.S. coronavirus cases, aided by the Federal Reserve's June 15 announcement that it would go ahead with purchases of corporate bonds.
The spreads on investment grade U.S. corporate bonds barely moved, decreasing from 158 basis points to 156 bps between June 16 and June 23.
Similarly the spread on emerging market corporate bonds ticked down from 409 bps to 404 bps by June 23.
"While the growth slowdown has been sharp, defaults and debt restructurings shouldn't indiscriminately wash across the emerging-market landscape," Polina Kurdyavko, head of emerging markets at Bluebay Asset Management, wrote in a research note.
However, heightened investor nervousness is revealing itself in the high yield market.
Having fallen back to 578 bps by June 16, the spread was up to 602 bps at the close of June 23. It was the second such spike in June after the spread widened from 550 bps on June 5 to 640 bps on June 11 before the Fed's announcement.
"[We] favor high grade over high yield on concerns about this cycle's default rate," said economists in JPMorgan's cross-asset strategy team led by John Normand. "[We] also choose developed market corporates over emerging market corporates given the greater challenges many emerging markets outside of north Asia face in managing the public health and debt sustainability issues triggered by COVID-19."
Money markets have stayed calm in recent weeks.
The Libor-OIS spread — a key risk indicator for the U.S. banking sector measuring the difference between the three-month dollar London Interbank Offered Rate, the average cost for banks to borrow from each other, and the overnight indexed swap rate — continued to contract, falling from 23.2 on June 18 to 21.3 on June 25.
The leveraged loan market also continued to grind lower, with the percentage of the S&P Global-rated U.S. loan index priced below 80 — a closely watched indicator of stress — falling slightly from 9.2% on June 16 to 8.1% on June 23.