Massive policy support not likely to derail Treasuries for long - Capital Economics
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Massive policy support not likely to derail Treasuries for long

Capital Daily
Written by John Higgins
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We wouldn’t be surprised if the massive policy support that has been announced in the US in recent days had some adverse effect on Treasuries in the second half of 2020. After all, similar support rolled out during the darkest days of the Global Financial Crisis (GFC) in 2008 was followed by a sell-off in the US government bond market in 2009. Nonetheless, we would anticipate a smaller rise in Treasury yields this time around. And we doubt that it would last long either, just as the sell-off in 2009 unwound during 2010. The simple reason is that, like it did after the GFC, the Fed will probably keep policy exceptionally loose for a very long time.

  • EU leaders set to discuss the use of “corona bonds” to fund the fiscal response to COVID-19
  • Singapore’s advanced estimate of Q1 GDP is likely to show a slump in activity (00.00 GMT)
  • We expect the Czech central bank to cut its policy rate by 75bp to 1.00% (12.00 GMT)

Key Market Themes

We wouldn’t be surprised if the massive policy support that has been announced in the US in recent days had some adverse effect on Treasuries in the second half of 2020. After all, similar support rolled out during the darkest days of the Global Financial Crisis (GFC) in 2008 was followed by a sell-off in the US government bond market in 2009. Nonetheless, we would anticipate a smaller rise in Treasury yields this time around. And we doubt that it would last long either, just as the sell-off in 2009 unwound during 2010. The simple reason is that, like it did after the GFC, the Fed will probably keep policy exceptionally loose for a very long time.

Chart 1 shows how the 10-year Treasury yield bottomed out in December 2008 at a little over 2%, very soon after the Fed cut its policy rate to 0-0.25%. However, the S&P 500 fell by nearly 25% more, before finally turning a corner in March 2009. In the meantime, the 10-year yield had rebounded to nearly 3%. It then rose towards 4% in the rest of 2009, as equities rebounded.

Chart 1: 10-Year Treasury Yield, Federal Funds Rate & S&P 500 Around The Time Of The GFC

Sources: Refinitiv, CE

It is too soon to tell whether the Treasury yield has already hit a floor this time around. Much of its rise from ~0.5% on 9th March has reflected fire sales. Even so, the pull-back in the yield as those sales have eased has not taken it back to that closing low. (See Chart 2.) And the S&P 500 could once again fall back before finding a nadir, without the yield revisiting its trough.

Chart 2: 10-Year Treasury Yield, Federal Funds Rate & S&P 500 Around The Time Of The Coronavirus

Sources: Refinitiv, CE

Back in 2009, the sell-off in the Treasury market was fuelled by several concerns. First, some believed that the Fed would not need to keep monetary policy exceptionally loose once the economic recovery became established. Second, some thought that its unconventional monetary easing would generate a lot of inflation. And third, some fretted about the implications of massive fiscal support for the US’s government’s creditworthiness. We argued then that these fears were largely misplaced – given the output lost during the GFC, monetary policy would need to remain very loose; ample spare capacity would prevent inflation from taking off; and the risk of a default by the US government was very slim. (See here.)

We have similar views today. The economic downturn is likely to be deeper, if shorter-lived, than during the GFC, which suggests that interest rates will again need to remain very low for a long time after the crisis is over. And US sovereign credit risk remains minimal in our view. So, we suspect that any sell-off in Treasuries driven by improved sentiment in the stock market will not last long again. What’s more, the sell-off in Treasuries in 2009 only reversed in 2010 once it dawned on investors that the Fed would need to keep policy loose for many years to come. We suspect that the need for this to happen again will occur to them more quickly in this instance, limiting any rebound in Treasury yields later this year. (John Higgins)

Selected Data & Events

GMT

Previous*

Median*

CE Forecasts*

Thu 26th

UK

BoE Monetary Policy Decision (Mar)

12.00

+0.10%

+0.10%

+0.10%

*m/m(y/y) unless otherwise stated; p = provisional


Key Data & Events

The $2trn stimulus package agreed by the Senate on Wednesday will include a permanent fiscal expansion worth up to 5% of GDP and, in conjunction with the new lending facilities announced by the Fed, it could channel up to $6trn in temporary financing to consumers and firms over the coming months. But even that won’t be enough to prevent a sharp decline in GDP in the second quarter, which we now expect could be as large as 40% annualised. Nevertheless, the measures should help to support a recovery once the coronavirus outbreak is brought under control. Otherwise, the durable goods figures for February suggest that business equipment investment was on track to stagnate in the first quarter, even before the domestic spread of the coronavirus crushed demand. (Andrew Hunter)

Europe

The Eurogroup agreed to create a “pandemic crisis support safeguard” at the ESM, which is likely to be similar to the ESM’s precautionary credit lines. But the amount of funding available will probably be small (around 2% of the applicant country’s GDP), and conditions may be attached to the loans, which could deter governments from applying. More details may be announced on Thursday, when EU leaders will discuss the block’s response to COVID-19. So called “corona bonds” (i.e. jointly-backed bonds to fund the fiscal response to the crisis) will also be on the agenda. These have already been endorsed by nine euro-zone leaders in a joint letter. Meanwhile, the downward revision to Germany’s Ifo Business Climate Indicator adds to the evidence that the German economy is collapsing, with services taking the worst hit. Otherwise, the German Gfk consumer confidence index and Sweden’s Economic Tendency Indicator for March are likely to have slumped.

The drop in UK CPI inflation from 1.8% in January to 1.7% in February is a sign of things to come. We think that inflation will average just 1.2% in both 2020 and 2021 meaning that even by next year, there may be little pressure on the Bank of England to raise interest rates from the current all-time low of 0.10%. Meanwhile, retail sales growth was probably a bit softer in February after a strong January, but grocery stores may have benefitted from stockpiling due to the coronavirus at the end of the month. (Melanie Debono & Ruth Gregory)

Other Developed Markets

In Canada, the central bank announced a new Provincial Money Market Purchase program and Parliament passed a $27 (1.1% of GDP) fiscal stimulus package. While this will cushion the blow, we don’t think these measures will be anywhere near enough to prevent a more severe slump. We forecast a 35% annualised drop in GDP for the second quarter. With the government saying that almost one million people have applied for Employment Insurance in just the last week, it already looks like the unemployment rate has nearly doubled to 10%.

In Japan, Tokyo Governor Koike Yuriko said on Tuesday that, should there be a sudden spike in infections in the capital, a Tokyo lockdown may be unavoidable. There were 17 new cases reported in Tokyo yesterday – slightly higher than previous days. (Stephen Brown & Tom Learmouth).

Other Emerging Markets

In Emerging Asia, the measures to contain the spread of the coronavirus in India announced by PM Modi last night will be hard to fully implement but will still have severe economic repercussions. We now expect the economy to grow by just 1% this year, the weakest pace since 1979. Elsewhere, the Bank of Thailand left interest rates unchanged at 0.75% at its scheduled meeting today. This follows a 25bp rate cut at its emergency meeting on Friday. With tourist arrivals down 98% since the crisis began, the country in lockdown and exports set to plunge, we think the economy will contract this year. As a result, we expect the central bank to lower its policy rate to 0.5% over the coming weeks. Meanwhile, Singapore’s advanced GDP estimate for Q1 will not have captured the impact of the slump in global demand in March (the figures are based on data from the first two months of the year). Nevertheless, given the disruption caused by the factory shutdowns in China in the first two months of the year and the drop in tourism, the figures are still likely to point to a sharp slowdown in activity.

In Emerging Europe, Russia’s President Putin postponed the constitutional referendum previously scheduled for April. If approved, the referendum would have allowed Putin to run for President for a further two terms. A range of measures to help households affected by the virus were also announced. Elsewhere, Turkey’s manufacturing capacity utilisation dropped in March, while economic confidence fell sharply. That said, the figures almost certainly didn’t capture the latest extent of the coronavirus outbreak, so figures for April are likely to be a lot worse. Meanwhile, we think that the central bank of the Czech Republic will cut its key policy rate by 75bp to 1.00% on Thursday. And with the economic disruptions from the coronavirus only likely to intensify, we expect the Bank to lower interest rates to 0.50% over the coming months.

In Latin America, the fall in Brazil’s inflation to 3.7% in the middle of March will allow the central bank to follow up its 50bp rate cut last week with a further 50bp of easing at its meeting in May, taking the Selic rate to 3.25%. But the scope for more aggressive easing is limited given the weakness of public finances and the vulnerability of the currency to a fresh deterioration in risk appetite.

In Sub-Saharan Africa, the central bank of South Africa launched a bond buying program to inject liquidity into local credit markets. The bold move enlarges the scale of the Reserve Bank’s response to the coronavirus outbreak and comes on top of last week’s 100bp rate cut and several emergency liquidity measures. (Darren Aw, Liam Peach, Jason Tuvey, Nikhil Sanghani & Virág Fórizs)

Published at 16.57 GMT 25th March 2020.

Editor: John Higgins (+44 20 7811 3912)

john.higgins@capitaleconomics.com

Enquiries: William Ellis (+44 20 7808 4068)

william.ellis@capitaleconomics.com

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