“Be calm. It will go away.”

“Be calm. It will go away.”

Written by The Investor

10 March, 2020

“Be calm. It will go away.”

Why the US will move to negative interest rates, and quickly, to beat the COVID-19 fallout   

 

Key points:

  • Will the virus create a global credit crunch.
  • Can central banks create a ripple effect.
  • What will happen to investment markets in the short term.

Last week central banks around the world cut interest rates. In Australia we hit an historic low of 0.5% while the US Fed also cut rates by 0.5% to a range of 1-1.25%.

A drop in mortgage rates leaves you with more cash in hand however we doubt very much that it will change your decision to fly or even go to the shops and spend these savings.

However, what did change people’s attitude was the fear of being left without essential household items.

Panic buying of rice, pasta, canned food and most prominently toilet paper has dominated Australian headlines! Japan has also seen a rush on toilet paper, while in France and the US consumers have been scrambling to get hold of food staples such as rice and pasta.

While cutting rates can bolster confidence and bring down borrowing costs, it cannot prevent disease from spreading or help companies deal with delayed orders or sick workers.

“We do recognize that a rate cut cannot reduce the rate of infection, it won’t fix a broken supply chain,” Fed Chairman Powell said. “We get that — we don’t think we have all the answers.”

 

So why did the RBA and the FED cut interest rates if it will not have any effect in boosting the economy?

“Faced with …. the coronavirus, the chances of the central banks being able to provide a positive stimulus to the real economies seem remote at this time and we doubt that fiscal policy (tax cuts or cash hand outs) will be able to achieve much more in the current situation”, says UK based Hunt Economics.

“What policy makers can however hope to do – and must do – is to keep the credit markets (banking system) open so as to avoid a worse slowdown or even a genuine depression. Corporate sectors and governments around the world are cash flow negative (losing money because of the shutdown) and we suspect that, as their revenues and tax receipts fall away in the slowdown, they will tend to become ever more cash flow negative. Consequently, they will need more not less credit (short term loans and support from their bankers), just as many did in the weeks that followed the Lehman Collapse (Global Financial Crisis of 2009).”

These are sobering words.  We should point out that Hunt Economics are well known for their non-consensus views, however, this time there is a strong case to listen as the world goes into a nosedive.

 

Will the virus create a global credit crunch?

This raises the potential risk of a credit crunch just as many need more funds to survive.  Should this happen companies will be forced to lay off workers, cancel growth projects, and even sell non-core assets at fire sale prices.

But it appears that the central Fed’s plan is starting to work.  This week we saw a flight to high quality assets like government bonds, and the sell-off of risky assets like shares.  According to Hunt it is not just investors but also the banking system (including central banks) that are buying government bonds, and as a result they are pushing down yields to historic lows. This was their aim. In fact, we would not be surprised if their aim was to push US treasuries into negative territory.

 

US 10 Year Government Bond Yield hits historic low

Picture 1 1

Source : macrotrends.net

In order to prevent economic growth from deteriorating it is vital that the major central banks become supportive so that the banks can keep lending in an environment where investors are shunning risk.

 

How lower central bank rates transmit into a more stable economic growth outlook 

The most likely way in which the Central Banks can be effective is by making the price of safe haven assets (government bonds) prohibitively expensive (negative interest rates) by directly purchasing government bonds using central bank funds i.e. quantitative easing is a process where they create money, then spend that money on government bonds effectively crowding out others from low risk investments (potentially pushing US 10 year treasuries into negative interest rates).

By shifting bond returns into negative territory they will impact the profitability of the banking system’s core lending business.  Banks currently use short-term funds on deposits to lend to governments, companies and consumers. If lending to governments becomes unprofitable, they will have to look elsewhere i.e. up the risk curve and lend to corporates, small businesses and consumers.  Without government incentives this seems unlikely at the moment.

So why would the central banks risk making the banking system unprofitable?  Well there is now a great deal more debt in the world than there was at the time of the GFC and this presents a greater risk should the banking system stop lending or call in bad loans.

 

Can central banks create a ripple effect?

While the central banks cannot control banking lending they can create a ripple effect by forcing money out of government bonds and into riskier assets like corporate bonds and shares.

There is a precedent for this in Europe right now. The European Central Bank (ECB) has forced bund yields so low that investors find low risk German bunds so unattractive that they must consider a higher risk assets in the TARGET2 plan.  More than 1,000 banks use TARGET2 to initiate transactions in euro, either on their own behalf or on behalf of their customers. Taking into account branches and subsidiaries, more than 52,000 banks worldwide and all their customers can be reached via TARGET2.

 

Picture 1

Source : Hunt Economics

Euro area credit institutions can receive central bank credit not only through monetary policy operations but also through emergency liquidity assistance (ELA).

 

A little bit of history helps us understand the importance of the $USD and the US Fed’s setting of global interest rates

One of the keys to solving the puzzle is understanding the link between the major economies, their banking systems and their exchange rates.

According to the International Monetary Fund, the U.S. dollar is the most popular in the world.  In 2019, it made up 61% of all known central bank foreign exchange reserves, suggesting it is the de facto global currency, even though it doesn’t hold an official title.

More than one-third of the world’s gross domestic product comes from countries that peg their currencies to the dollar. That includes seven countries that have adopted the U.S. dollar as their own. Another 89 countries keep their currency in a tight trading range relative to the dollar.

The 1944 Bretton Woods agreement kick-started the dollar into its current position. Before then, most countries were on the gold standard. Their governments promised to redeem their currencies for their value in gold upon demand. The world’s developed countries met at Bretton Woods, New Hampshire, to peg the exchange rate for all currencies to the U.S. dollar. At that time, the United States held the largest gold reserves. This agreement allowed other countries to back their currencies with dollars rather than gold.

 

Proof we are back-to-the-future by observing US Fed policy impact on world growth

According to Hunt; “In 2017, failures at the Fed clearly left USD conditions too lax and the world ‘boomed’ as a result. In 2018, the Fed over tightened and the global economy screeched to a halt.  In late 2018 and early 2019, the Fed relented, and the world stabilized.”

This explains why much of Asia did not drop interest rates in January and February.  The People’s Bank of China (PBOC) has been measured, cutting rates by just 10 basis points to 4.05%, and instructing lenders to go easy on stressed business borrowers rather than adding to the problem by calling in bad loans. The PBOC gave banks an extra 800 billion yuan (US$115 billion) in February to lend out to struggling businesses and farmers.  We suspect there is more of this to come.

In Korea, the central bank has not made any changes and could be said to be in denial. Governor Lee Ju-yeol said he saw limits to what monetary policy can do to counter the virus.  Clearly, he needs to get with the global monetary program!

Hunt Economics estimates that as a result of the economic slowdown, China’s banks will have a ‘funding gap’ this year that will be the equivalent of circa 5% of Global GDP and that they will need to fund a substantial amount of this in USD. That’s one third of China’s economy in funding. To do this they need to attract global capital, and this means they need to keep interest rates higher than those in the US.

So China, and much of the world, needs US government bonds to offer zero to negative returns.  This will force the world’s banking system to fund China and other COVID-19 affected economies.  They will then be able to support their banking system, which then supports local businesses.

You see, dropping interest rates is really not for the benefit of the consumer in an economic crisis like this.  It is about resetting the risk-free rate of return to be unattractive so that the world’s banking system takes more risk and supports world commerce with increased funding.

 

Article: Why China matters so much pre and post lockdown

What will happen to investment markets in the short term

As discussed previously, there are two scenarios (Contain & Outbreak), and presently the dominant scenario is still Outbreak.  In this environment share returns will ratchet down as earnings downgrades come through and market premiums are reassessed.

Interest rates will continue to be lowered by central banks. As a consequence, bond yields will drop as the central banks try to facilitate an environment whereby banks take more risk. By doing so they attempt to keep credit markets open and funds in the economy flowing.

Share markets are coming off all time highs. In the US the years of buybacks funded by corporate debt issues has left that market vulnerably geared.  In Australia we have the commodity risk factor as we enter a global slowdown and also an overinflated banking sector that is exposed to highly leveraged mortgagees.

Depending on how long the Australian economy takes to slow, and to what extent it does slow, there will be a delayed impact on the Australian property market.  The Australian property market is very strong at present based on demand outstripping limited supply.  While supply is growing there seems to be built up demand from the downturn of 2017/2018.  It can be argued that Australian property is currently operating in its own bubble that may continue if the Contain scenario eventuates.

 

 Market Impact

Scenario (feb 20)
31/12/194/2/20ContainOutbreakLatestLatestNew Outbreak forecast
01.03.2008.03.20
ASX 3006647691570006000639561745750
S&P 5003230322533002900295429722600
Shanghai comp.3038273530002000288030342000
Crude oil price$60.70$50.50$55$45$44$45$35
US 10Y treasury1.80%1.50%2.00%1.20%1.38%0.74%-0.10%
Residential Property3%-5%1.20%tba-5%
$A vs $US70.167.27060656658
RBA rates0.750.750.50.250.750.50

 

However, for the moment with 20,000 news cases worldwide since last week, and most of these being outside of China, the Outbreak scenario is dominant. As discussed last week in depth the situation in Iran and also Italy is deteriorating rapidly (7,161 & 9,172 respectively), as it is in other European countries like France (1,209 cases), Germany (1,176 cases) and in the US where surprisingly they have only really started testing.  US cases are rising by hundreds each day (currently 607).

 

Be calm it will go away

The good news is that most governments around the world are working together to develop a plan for containment and financial support. On Friday President Trump, wearing his “Keep America Great” campaign hat while discussing the global worry, repeatedly detoured from his message of reassurance while visiting the Centers for Disease Control and Prevention.

Trump called Washington state’s governor, who is dealing with the most serious outbreak in the nation, a “snake.” He said he’d prefer that people exposed to the virus on a cruise ship be left aboard so they wouldn’t be added to the count for the nation’s total number of infections.

Trump also signed a bill funding $8.3 billion to provide federal public health agencies with money for vaccines, tests and potential treatments.

 

“Be calm. It will go away.”  were the President’s closing remarks.

 

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Please consult your advisor for specific recommendations.  This general advice does not take into account the client’s objectives, financial situation or needs as we do not and cannot provide personal advice.  Any views written about in this article are the views of the author who has no holdings in those companies or investments mentioned in this article.