Fed-inspired bounce may already be fading - Capital Economics
Capital Daily

Fed-inspired bounce may already be fading

Capital Daily
Written by Jonas Goltermann

Although equity markets are staging a tentative rally today on the back of renewed hopes that policymakers will save the day, our view remains that until there are clear signs that the coronavirus pandemic is abating, equities and other risky assets will remain under pressure and could easily fall further.

  • FOMC likely to cut rates by 50bp, but 100bp possible (Wednesday)
  • We think that the Bank of Japan will cut its deposit rate to minus 0.2% (Thursday)
  • A fall in the real means Brazil’s central bank is likely to stand pat (Wednesday)

Key Market Themes

Although equity markets are staging a tentative rally today on the back of renewed hopes that policymakers will save the day, our view remains that until there are clear signs that the coronavirus pandemic is abating, equities and other risky assets will remain under pressure and could easily fall further.

Yesterday’s plunge in global equity markets was the worst in a single day since Black Monday in 1987. The overall turmoil in financial markets is now as bad as at any time since the global financial crisis in 2008-09. The US Libor-OIS spread and the cross-currency swap basis of major currencies vis-à-vis the dollar – the additional cost to non-US borrowers of obtaining dollar funding – have widened sharply over the past week. While both have eased a little today, and remain well below their 2008 peaks, the speed at which they have blown out suggests significant strain in money markets.

A sign of just how bad things have become is the fact even assets which typically act as safe havens lost value yesterday. For example, the price of gold fell, and the Japanese yen lost ground against the dollar. That is consistent with widespread forced selling from market participants facing redemptions and margin calls, and non-US banks struggling to maintain wholesale dollar funding, which is similar to what happened during the worst of 2008-09 and the 2011-12 euro-zone crisis.

Another worrying pattern is that the yield of 10-year US Treasuries has risen sharply this week, from below 40bp on Monday to about 90bp now, even as equity markets have plunged. (See Chart 1.) Normally rising bond yields reflect expectations that an improving economy will lead to tighter monetary policy. But that is difficult to square with equities plummeting and the fact that interest rate expectations in the US have fallen to near zero. Indeed, investors now discount the fed funds rate remaining there for at least the next two years. So some of the rise in bond yields may reflect distressed selling even in the deepest and most liquid of markets.

Chart 1: S&P 500 & 10-Year US Treasury Yield (%)

Sources: Refinitiv, CE

Today’s equity rally and the slight easing of money market strains suggests that the Fed’s decision yesterday to resume purchasing Treasuries and provide large-scale repo funding over the next few days has helped relieve the worst of the strain, at least for now. Stimulus announcements from the PBOC and other central banks, as well as the ECB’s attempts to restore confidence following Christine Lagarde’s less-than-reassuring press conference will also have helped, as will indications that fiscal measures are on the way in both Europe and the US.

Policy stimulus and steps to shore up the plumbing of the financial system will help cushion the blow to the global economy and, probably, avoid a destabilising break-down in the supply of credit. But in our view, it is unlikely to spark a sustained rally in risky assets. After all, unlike in 2008-09 and 2011-12, the core of the problem today is not the health of the financial system or strains in government bond markets, but the continued spread of the virus. Uncertainty about how long the measures to contain it will remain in place and how much economic damage the increasingly widespread shutdowns will cause is the key factor driving equities lower. We still don’t think that equities will recover on a sustained basis until there is evidence that the pandemic is fading and economies recovering. (Jonas Goltermann)

Selected Data & Events

GMT

Previous*

Median*

CE Forecasts*

Wed 18th

US

Fed Policy Announcement

18.00

1.00-1.25%

0.75-1.00%

0.50%-0.75%

Thu 19th

Jpn

Bank of Japan Policy Announcement

-0.10%

-0.10%-

-0.20%

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

Key Data & Events

US

The New York Fed announced late on Thursday that it would dramatically increase the size of the Fed’s repo auctions, to ease recent pressures in money markets. More significantly, the Fed has also tweaked its existing balance sheet expansion, with the $60bn of monthly T-bill purchases now expanded to target Treasury bonds of all maturities. The latter amounts to a full-blown return to quantitative easing, and we expect the Fed to label it as such at next week’s FOMC meeting. The monthly pace of asset purchases may also be expanded too. What’s more, we expect officials to cut interest rates by a further 50bp, but the Fed may surprise markets with a 100bp cut. That would take the fed funds rate back to its crisis-era low of 0.0 to 0.25%.

Meanwhile, reports suggest that the Trump administration and House Democrats are closer to agreeing a fiscal package to support the economy, although any deal seems unlikely to include the major tax cut that Trump had called for. Otherwise, while the fairly modest fall in the University of Michigan consumer confidence index in March suggests that consumers aren’t yet overly concerned about the coronavirus, we suspect the data are already a little out-of-date. (Andrew Hunter)

Europe

European governments have stepped up their efforts to contain the coronavirus, with schools closed in France, and Spain declaring a state of emergency. Norway’s central bank followed its announcement on Thursday that it will provide unlimited liquidity to banks with an emergency 50bp rate cut on Friday morning. Sweden’s Riksbank also announced measures meant to keep credit flowing to households and firms.

Next week, we doubt that euro-zone finance ministers will be able to agree a coordinated package of fiscal measures at Monday’s Eurogroup meeting. We will also get the first of the March surveys. The ZEW on Tuesday will show how investors think Germany’s economy will be affected by the virus. Finally, we think Switzerland’s central bank will follow in the footsteps of others, and cut its policy rate, to minus 1.00%.

Reflecting the impact of the coronavirus containment measures that we expect in the UK, we have revised down our forecast GDP growth in Q2 to minus 2.5%. We also now expect the Bank of England to cut its policy rate by a further 15bp, to 0.10%, and resume quantitative easing at its meeting on 26th March. This should prevent the heath crisis turning into a prolonged recession. Next week’s data releases for the UK – January’s labour market data and February’s public finances figures – have been made more or less irrelevant by recent events. (Melanie Debono & Andrew Wishart)

Other Developed Markets

The data for January on Canada’s economy is already old news, as is New Zealand’s Q4 GDP data. However, in February, Canada’s consumer price inflation probably fell sharply, but house price inflation seems to have picked up. We also expect a rise in Australia’s unemployment rate last month, to 5.4%.

Finally, we expect the Bank of Japan to cut its policy rate to minus 0.2% on Thursday. We also expect an improvement in the trade balance in February, but inflation is likely to have dipped to 0.5%. (Stephen Brown, Ben Udy & Tom Learmouth).

China

The People’s Bank reduced the required reserve ratio for all banks that meet targets for lending to SMEs and private firms. This will release additional liquidity, pushing down interbank rates and leading to lower borrowing costs for firms and households. We think the PBOC’s ongoing monetary easing efforts should drive a pick-up in credit growth later this year, providing a tailwind to the post-virus economic recovery.

February’s activity and spending figures will undoubtedly show some sharp falls. But it is still unclear if authorities will acknowledge the full extent of the recent weakness, given that the data feed directly into the politically sensitive GDP figures. On Friday, we expect banks to lower their Loan Prime Rates, the benchmark rate against which all loans are priced. (Martin Rasmussen)

Other Emerging Markets

In Emerging Asia, Central banks in Pakistan, Taiwan and the Philippines are all likely to loosen monetary policy next week. In contrast, the slump in the rupiah over the past month means that Bank Indonesia will probably leave rates on hold.

In Emerging Europe, we think the Turkey’s central bank will cut its policy rate by a further 50bp, to 10.25%, on Thursday. If anything, the risks are skewed towards a larger cut. In contrast, the sharp drop in the ruble this week probably takes easing off the table in Russia, whose central bank meets on Friday. We expect the policy rate to be left unchanged at 6.00%.

In Latin America, the outcome of Brazil’s central bank meeting on Wednesday will be a close call. On balance, we think the fall in the real will prevent the bank from loosening monetary policy further. We should also get more details on potential government stimulus plans in Mexico and Brazil next week, but weak public finances limit the room for a big response.

In the Middle East and North Africa, Lebanon’s sovereign default is likely to be confirmed on Monday, when a grace period on a $1.2bn Eurobond repayment expires. A swift restructuring deal looks unlikely.

Finally, in Sub-Saharan Africa, we think that policymakers at the South African Reserve Bank will cut their key policy rate from 6.25% to 6.00%, in an attempt to provide support to the economy, which we think will contract again in Q1. (James Swanston, William Jackson, John Ashbourne & Gareth Leather)

Published at 16.42 GMT 13th March 2020.

Editor: John Higgins (+44 20 7811 3912)

john.higgins@capitaleconomics.com

Enquiries: William Ellis (+44 20 7808 4068)

william.ellis@capitaleconomics.com