The Beatings Will Continue Until Morale Improves

Published on March 9, 2020
SGH Insight
Tim Duy's Fed Watch:

The Fed may have to act again before the next meeting, like Monday morning. Although last week some Fed officials like St. Louis Federal Reserve President James Bullard floated the idea that the Fed simply moved up the March rate hike, such comments shouldn’t be taken too seriously (the blackout period couldn’t come soon enough).
There is just too much uncertainty for the Fed to try to hold off on further easing and a strong argument for delivering more easing sooner than later. Given low inflation low and market expectation that it falls further, the low-risk, high-reward policy position argues in favor of additional easing.
Realistically, the Fed should be discussing just taking rates to zero and getting very far out ahead of the data but they tend not to react that quickly. Bond markets are telling them to do it. I don’t have a strong argument for gradualism in this environment. If you take rates to zero, you maximize the odds of getting ahead of the weakness. If you can’t get ahead of the weakness, you are going to zero anyways. In either case, once you get back to the zero bound, then you need to look at QE, yield curve control, forward guidance, liquidity provisions, etc.
Market Validation
(FT 3/15/20)

The Federal Reserve cut US interest rates to zero before financial markets opened on Sunday and joined forces with other central banks in a bid to prevent a severe economic downturn caused by the coronavirus pandemic. After three weeks of chaotic drops in global stock markets and alarming signs of dysfunction in the US government bond market, the Fed stepped in with tools it has not used since the financial crisis. The sweeping measures underscore the severity of the damage that the coronavirus has already caused to economic growth, and the threat the outbreak poses to financial stability. The Fed dropped its policy rate by a full percentage point to a range of 0-0.25 per cent, a level not seen since 2015. It also announced wide-ranging actions to support financial markets, including an additional $700bn in asset purchases, expanded repurchase operations, dollar swap lines with foreign banks and a credit facility for commercial banks to ease household and business lending.

Markets are in motion overnight as we go into what promises to be another wild week. The coronavirus remains the focus of everyone’s attention, and for good reason. Unfortunately, the bad news seems likely to keep coming this week as testing ramps up in the U.S. In this environment, there seems to be little hope to expect stability in financial markets.

The blackout period ahead of next week’s FOMC meeting leaves us with no new planned guidance from the Federal Reserve. The expectation among market participants is that another big rate cut is coming. Strained credit markets will bring the Fed to the table more quickly. Given what is happening overnight, Monday morning the Fed could be pulled back into action.

The novel coronavirus Covid-19 is out in the wild; containment seems to be a long-lost hope. In the near term, we are hoping to suppress the pace of spread of the virus and limit the strain on medical resources. “Social distancing” will be the new norm for the next several weeks, the costs of which will fall most heavily on travel and tourism. For example, persons at most risk are now being advised to avoid large groups, long trips, and cruise ships. People will be encouraged (or ordered by employers) to work from home when possible. We will see more school closures. The University of Washington and Stanford University both closed campuses. This will likely be a theme this week

As testing kits become more available, the number of confirmed cases in the U.S. is likely to climb. This will be something of a double-edged sword. In the near-term, the rising numbers will fuel additional fear and uncertainty. But, over the longer-term, we can’t start thinking about the other side of this until we get a better handle on the size and scope of the challenge. 

Until we can see the other side, there will be a rational tendency to focus on worst case scenarios. That implies the theme of risk aversion will continue. Stock rallies will be short-lived and market participants will lean toward safe assets – as evidenced by the fall in 10 year treasury yields to 0.5% Sunday night.

Markets are not looking good Sunday evening. Stock futures are off sharply; equities might open down in more than 4% Monday morning. Oil prices have collapsed, down a staggering 30% as Saudi Arabia meets weak demand with a price war. Note that this has mixed effects on the U.S. economy. Lower oil prices are good for consumers but will hammer energy producing regions and highlight credit risk in the sector.

Market participants clearly expect considerable economic pain in the months ahead. To be sure, we don’t how much of the action right now is overshooting. Memories of the last financial crisis run very, very deep and as a consequence market participants could be prone to excessive panic. Still, even if excessive, such panic can have very real consequences if credit markets begin to freeze. The Fed needs to be ahead of worsening problems in credit markets to prevent panic from becoming a reality.

The Fed may have to act again before the next meeting, like Monday morning. Although last week some Fed officials like St. Louis Federal Reserve President James Bullard floated the idea that the Fed simply moved up the March rate hike, such comments shouldn’t be taken too seriously (the blackout period couldn’t come soon enough).

There is just too much uncertainty for the Fed to try to hold off on further easing and a strong argument for delivering more easing sooner than later. Given low inflation low and market expectation that it falls further, the low-risk, high-reward policy position argues in favor of additional easing.

Realistically, the Fed should be discussing just taking rates to zero and getting very far out ahead of the data but they tend not to react that quickly. Bond markets are telling them to do it. I don’t have a strong argument for gradualism in this environment. If you take rates to zero, you maximize the odds of getting ahead of the weakness. If you can’t get ahead of the weakness, you are going to zero anyways. In either case, once you get back to the zero bound, then you need to look at QE, yield curve control, forward guidance, liquidity provisions, etc.

It would help greatly if the Federal government could pull together a fiscal rescue package sooner than later. Or at least look like they have a grip on the evolving situation. Good luck with that; we were lucky to the meager funds of last week. Sad to say, the Federal Reserve remains the only game in town.

Is there any good news? Yes. The U.S. economy was entering this crisis with some momentum as evidenced by a number of indicators including the March employment report. In addition, manufacturing had been firming and the housing market was set to make further gains. On housing, the demographics are in our favor and the market will be given a boost by lower mortgage rates. Those lower rates are also driving a refinancing boom and thus are providing additional support to the economy. 

All of this will matter on the other side. But no one cares right now. Even if we know there is another side to the crisis, we still can’t fully judge the depth and length disruption ahead of us. Anyway you cut it, the near term is ugly.

Bottom Line: As testing ramps up in the U.S. this week, so too will the number of confirmed cases. With more confirmed cases will come more disruptions. Lacking any clarity, fear remains the dominant financial market theme. If the Fed learned anything from 2007-09, they need to go big and go fast if there are even hints of credit market disruptions. That should drag them into action sooner than later. More rate cuts and/or liquidity measures to maintain market functioning could come very soon if not Monday morning.

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