Markets in the US are poised for another day of heavy selling as the weekend approaches. And the worry has to be about having open positions over the weekend when any bad news would cause heavy selling pressure at market open on Monday. So, the potential for a serious downdraft today increases. And so, we are now getting to the point where policy makers must be thinking about how they can prevent a market panic leading to a liquidity crisis and recession.
Policy is reactive, not proactive
I think Kevin Muir summed it up nicely at his Market Tourist Newsletter yesterday:
The market will now continue punishing the Fed until they give them the liquidity they are demanding
Globally, policymakers have been caught out here. Before the coronavirus hit, all of the major central banks were studiously moving toward a more hawkish position. And their intransigence here in the face of the market selling owes to that.
Central banks are loath to be seen capitulating to market tantrums. They do not want to be seen reacting to equity markets because that encourages traders to take on more risk in the belief the Fed will always be there to bail them out. But, at this point, they have no choice.
The question now goes to whether we see a coordinated global response at the weekend. Some market commentators are suggesting we will. I doubt it for a couple of reasons.
First, if you look beyond monetary policy, to finance ministers or the like, comments by the Trump Administration suggest they are still in a state of denial for fear of being blamed for a slow-footed response. For example, look at White House acting Chief of Staff Mulvaney’s comments today:
Mulvaney is saying that the press is now covering Coronavirus because “they think this will bring down the president. That’s what it’s all about.”
— Annie Karni (@anniekarni) February 28, 2020
There’s going to be no coordinated fiscal or governmental response without the United States. And the US is clearly not prepared to act yet. So that leaves it to central banks.
But monetary policy is generally reactive and not proactive. That’s why we’re seeing markets force policy makers into action. And so, I am sceptical that policy makers will go from zero to 100 over the weekend. I still don’t believe we will see inter-meeting cuts from the Fed either.
So, the most we can hope for is calming words on an ad hoc basis. That will likely not be enough. And I think momentum will carry us down further today, setting up Monday for a potentially turbulent open.
What are markets signalling?
So, the question now is what is the signal we can glean from market price action. For example, if you look at the yield curve. It has inverted steeply from 3 months to 3 years, but remains steeply upward sloping after. The 3-month Treasury is trading at 1.326% with inversion down to 0.964% for the 3-year. Afterwards, yields rise to 1.201% for the 10-year and 1.708% for the 30-year.
As I am at pains to stress, this is not a recession warning. It is a policy warning – or policy forecast, if you will. It is the market saying that the Fed must or will cut steeply to avoid a recession. That’s what the front-end inversion is about. And, at some point over the longer term, the economic pain will subside and a normal yield curve environment will resume. That’s what the back end of the curve is saying.
A lot of people are talking about the summer’s inversion followed by a curve steepening as a bad sign because it is the pattern we saw before recession in both 2001 and 2007. I think this is something to keep in mind, that we had already seen a 3-month to 10-year and a brief 2-year to 10-year inversion last summer. The steepening now comes after that initial inversion.
I am still looking at the 2-year to 10-year upward slope as a sign that policy makers still have an opportunity to avoid recession. This slope is also steepening, and is presently at 24 basis points. What would concern me is if the 10-year sold off to, say 1% while the 2-year barely budged and the curve re-flattened. To me, that is a sign of a U- or L-shaped recovery expectation.
The L-shaped recovery
I am not an epidemiologist. So, I will assiduously avoid making comments about the science of disease. However, the latest news does show infections rising globally, with first cases in many different countries. Cases in Iran and South Korea are soaring as are the death counts. And we’ve seen the first cases registered in Mexico and Nigeria. See the latest news from Bloomberg here.
Two things here. One, Germany has now quarantined 1,000 people and Switzerland has banned large congregations outright, including the Geneva car show, which has been canceled. That shows you the lockdown and quarantine approach we saw in China is going to make its way globally. That’s bad for economic growth in the short-term.
Two, the disease spread to Nigeria is worrying because we now have infections in Sub-Sharan Africa. And the human toll could be horrific if the disease spreads in underdeveloped countries there. This has the makings of a true epidemic.
I think we have to consider the prospect of U- or L-shaped outcomes. The V-shaped outcome is almost certainly out now that the virus has gone global with the attendant lockdown and quarantine prevention methods. For example, Hyundai has shut down production after a factory worker tested positive for the virus.
Moreover, we don’t know the incubation period or whether the chance of re-infection is a worry once lockdown prevention methods are relaxed. China will be the first test of that. But, we should be prepared for economic disruption to increase both in severity and duration as the problem moves from supply chain, increasingly to supply side constraints and demand destruction globally.
I know it seems irrelevant right now but the latest GDPNow print from yesterday for Q1 2020 was 2.7%. To me, that gives you a sense of how well the US economy was doing pre-coronavirus outbreak. And so, it gives you a sense of how far we have to fall to induce an L-shaped outcome and recession in the US.
The US Personal income and Outlays series just came out for January 2020. The personal income number was well above expectations at 0.6% m-o-m, while personal consumption lagged expectations slightly at 0.2% m-o-m.
For me, the evidence suggests the US will be the last domino to fall into an L-shaped trajectory.
My View
Monetary policy is not going to fix supply bottlenecks or demand destruction from a pandemic. But, at a minimum, it can provide the impetus for a U-shaped outcome via the housing sector. The housing sector is one sector that should do well as interest rates fall because it means lower rates on mortgages. And that should flow through to greater mortgage refinancing as well as to potentially more housing activity.
But the longer this crisis goes on, the less the baseline and rate policy is going to matter. demand destruction dynamics will feed through into lower production, lower investment, and layoffs.
I think a recession is a foregone conclusion for Europe and Japan, and probably for the global economy as well. For the US, the clock is ticking. Tightening financial conditions could soon mean defaults and bankruptcies that amplify the economic slowdown. Let’s see what kind of policy response we get today and at the weekend.