We are now facing the potential for a severe financial crisis, with all asset markets showing major moves toward safe haven assets. What has precipitated panic is the Saudi oil price cut at the weekend because it has caused oil prices to plummet some 30% overnight and raised the spectre of a wave of defaults in the energy space. Some comments below
Three different areas of downside risk
Bloomberg News’ Joe Weisenthal laid out a good macro framing for thinking about the risks here. First, there is the fear associated with a global coronavirus pandemic. That’s a health crisis with real economic consequences. But on top of that is knock-on economic fallout in the form of supply-chain disruption, event, flight and cruise cancellations as well as school and workplace closure. The oil price shock only adds to the problem by creating a financial crisis in the energy that, pun intended, is infecting the rest of financial markets.
The fact that we now have three different broad areas of downside risk, all with a great degree of uncertainty regarding their magnitude and duration, means a broad rush to safe assets – and this does not include bitcoin, by the way.
And, let’s not forget that that all of this points to a major global recession and financial crisis as the worst-case outcome, with assets increasingly priced accordingly. The case for policy intervention has never been higher.
Here is a rundown of where some of the action is right now:
- Brent and WTI are both down 23%. These numbers could go lower as Russia has warned it could withstand $25-$30 a barrel oil for 6-q0 years (link here)
- Overnight, the 10-year and 30-year US bond yields fell to record lows below 0.50% and 1.00% respectively. This may seem like an irrational rush to safety. But, it is aided by the convexity hedging I told you about earlier and brings the US more in line with the rest of the world. I continue to see the UK curve as the bogey for the US, given that the countries have similar macro constraints (fiat currency, floating exchange rate, independent central banks, current account deficits)
- The Bloomberg commodity index is its lowest since July 1986, and close to its low since inception. (chart here)
- Gold is soaring. It is at a 7-year high
- Bitcoin is imploding, down some 9 1/2%
- In the currency space, the euro is bid and the Canadian dollar is selling off as the rush to safe haven currencies gathers steam. The Japanese yen has sold off on comments by Japanese officials that they will not sit idly by as the currency appreciates
- In equity markets, we have a limit down futures situation. Market circuit breakers are likely to be tested (link here on circuit breaker levels)
- “Cullen/Frost Bankers – the eye of the storm Texas bank with heavy exposure to the oil & gas industry. Also gets nailed by collapsing interest rates.” (link here)
- Germany‘s Banks Index plunged to All-time low as banks face perfect storm w/coronavirus and oil crash (link here). And note the systemic risk from an implosion in Deutsche Bank
- In credit markets, we are seeing yield divergence in Europe, with Spain, Portugal, Italy and Greece all selling off as investors rush to higher quality euro paper. I am seeing this both in 7-year and 10-year spreads.
- Investment grade CDX is at the highest since February 2016 and has risen the most since the Lehman crisis (link here)
- That tells you this isn’t just about risky assets like equities and high yield – where the HYG high yield ETF was down 4.5% in early pre-market trading. That shows contagion risk. It says the flight to quality is also out of IG bonds and to Treasuries.
We are seeing very limited reaction from policy makers here. The New York Federal reserve has announced that it will Increase the amount it is offering in daily overnight repo operations from at least $100 billion to at least $150 billion (link here). Nevertheless, in my view they have completely bottled it. They had the opportunity to get in front of this with a Standing Repo Facility. And they failed. Now they face a market panic and liquidity crisis with an ad-hoc policy infrastructure, making it up as they go along. It does not instill any confidence whatsoever.
I think the Fed has to cut 50 basis points relatively soon, and that they go to zero in short order. The reason yields are so low at the back end of the curve is that markets expect this too. They now realize that the Fed is converging to zero on base rates over the longer-term with the rest of the world. And that means our yields look more like theirs – the UK curve being my bogey for the US.
In terms of responses we want to see, the Australians are out in front here. They have proposed a $6.6 billion stimulus package. In US terms, that’s almost $90 billion, an order of magnitude greater than what the US has done. I don’t expect anything from Trump or Congress until it’s too late. And that has caused me to revert back to my previous position of looking at recession as a base case for 2020 because of a poor policy response.
Frankly, I have resisted making that call. But, the premise for that call seems very real now. Here’s what I said in August:
So, by the end of 2020, I expect the accumulation of policy errors by the Fed, the eurozone, the Trump administration and others to combine with an already slowing global economy to push even the US into recession. Germany is likely already there. The same goes for the UK. The same is true for Asian countries like Singapore, given recent data. The US is not immune.
That’s my base case.
Watch to see if the US Treasury curve fully inverts out to seven years. That’s next on the horizon. That’s when I think we reach a point of no return.
Curve inversion is now back to two years. That’s up from the 6-months we saw on Friday but much better than August. So, while recession is my base case, it is not a lock yet.
Claudia Sahm, a must-follow on Twitter and former Fed economist, is raising the alarm bells, saying now is the time to act. She has outlined a specific policy response she thinks could work (link here).
I don’t think Sahm’s plan will get a viewing. The Fed is reactive, not proactive.
On the fiscal side, one reason I am pessimistic is that Trump seems stubborn. He doesn’t want to acknowledge that there is economic pain coming. And so he is inclined to do nothing except micro targeted measures until it’s too late. Former Trump official Gary Cohn is out front exhorting him to do something for at least the most vulnerable. His view is that a large fiscal package is less necessary than measures that address those left in the lurch by the coronavirus epidemic. See this Twitter thread here. It’s very good.
This is looking very bad to me. We do have the makings of a liquidity crisis that becomes a full-scale financial crisis. As a hedge fund friend told me though, “I’m not sure to what extent algo programming has been switched to sell rather than buy dips”. I think we will see passive sell around the -20% mark on the S&P. Then things will go south fast.
That’s when all hell breaks lose. I’m hoping it doesn’t get that far. We ‘re in for a bumpy ride now though.