The awesome scale and scope of the coronavirus pandemic is now becoming clear as countries around the world enter lockdown and quarantine. And financial markets are in turmoil as a result.
I am writing this before the open in NY. But already, futures are limit down. And expectations are not for a bounce, but a fall to the circuit breaker level of down 7%, and a further fall once the 15 minute trading halt is over.
VIX Futures, a gauge of fear, is at its highest levels since the Great Financial Crisis. I also see that precious metals are down – platinum 18%, palladium 12%, gold 4%. It suggests the need for liquidity in US dollars.
Basically, we are now in a financial crisis.
The Fed policy response
This is all happening after the Federal Reserve announced a massive 100 basis point cut in interest rates and coordinated policy response with other central banks, ahead of the FOMC meeting later this week. The Fed also said it was going engage in $700 billion of large scale asset purchases of Treasury and mortgage-backed securities aka quantitative easing.
In fact, it was the Fed’s announcement that it would cut by a full percentage point, do massive QE and offer US dollar swap lines with other central banks that precipitated the crash in futures markets. Perhaps it was the realization that monetary policy will not be enough that caused it. I don’t know. But my initial view after Fed Chairman Jerome Powell spoke was that he did just fine in outlining the Fed’s position.
But, the fact remains that the Fed is done here. And their actions can’t change market tone simply because the Fed are not magicians. They can’t do anymore. We simply don’t know where the bottom is for the global economy or how overwhelming this pandemic is likely to be. People are simply panicked. And so, they are fleeing for safety.
Judging from how this is proceeding, I believe there is a chance that governments will simply shut down the stock market to prevent further panic.
The liquidity crisis
Before governments can move in and shut things down, we have to worry about a liquidity crisis though. All financial crises are liquidity crises, where illiquidity and insolvency are indistinguishable. And regulators are called on to provide liquidity in order to quickly divide the insolvent from the illiquid so that the financial system doesn’t break. How quickly authorities do so will impact how much damage gets done to our system.
Let me dust off the language from a post I wrote on February 27th:
Since the financial crisis of 2007-2009, the structure of many markets has changed dramatically. For example, in equity markets, passive investment strategies have become a dominant factor. In money markets, collateralized repurchase agreements now dominate the market for overnight liquidity. These changes have not been battle-tested enough though. And, in market downdrafts, this fact could amplify volatility and downside risk.
A couple of weeks ago, I mentioned the fact that the Fed is looking into ways to ‘fix’ the repo market, so that should a liquidity crisis occur, the market won’t freeze up. A standing repo facility is one way to get there. But Fed insiders leading the policy implementation like Randal Quarles are not sold on this fix. So, the Fed has dragged its feet on a solution. Repo could be tested. Last week, I wrote that the downside risks of coronavirus are mounting and said that “even though I think Quarles is telling us that a Standing Repo Facility is coming eventually, he is also not supportive of a Standing Repo Facility yet. That tells you that changes at the Fed to gear up for a potential liquidity crisis are not going to happen overnight. And that means the repo market is still vulnerable, dependent on ad hoc Fed decision-making to avoid hiccups that significant; tighten financial conditions or lead to a crisis.”
In equity markets, the vulnerability is what I would call automation. And it’s two-fold. One problem is the mechanistic way that ‘liquidity’ is added to the market via passive investment strategies. By that, I mean that most ordinary investors are convinced that timing the market doesn’t work. So, the best approach is to simply allocate funds to the market at all times in a mechanical way, irrespective of whether prices are rising or declining.
This approach works when markets don’t have major downdrafts. In fact, it may insulate markets from corrections. On the other hand, animal spirits have not been waved away by passive strategies. If event risk – like the coronavirus – overwhelms the passive insulating factor, you will get equity market withdrawals that amplify downside risk.
I spoke to Thomas Peterffy, the founder of Interactive Brokers, a couple of weeks ago for Real Vision (link here). His view is that high-frequency trading has changed market structure in a way that makes the market vulnerable to flash crashes. He says ” there is no chance for somebody to withdraw a limit order, they will not be putting it in, and therefore there won’t be anything to stop it and it may go down 10%, 20, 30% and then the people who are carrying big positions on leverage, suddenly become unable to pay for the losses, and then the whole thing may come down as in the time of Lehman Brothers.”
My View
Above I didn’t even mention what I have been calling fake liquidity where exchange-traded funds of illiquid assets like high yield bonds are traded as if the underlying market isn’t illiquid. But there are tons of market structure issues like this.
My View
This is exactly where we are right now. We are about to find out how robust our market structure is and how adept our regulators and central banks are at navigating a financial crisis.
Again, there is a sense in which regulators might feel justified in just ‘shutting it down’ to prevent things from breaking. We’ll just have to see how manic markets are today.
But, my focus is on fiscal policy. The only way that markets can get any sense of calm is knowing that there is a floor underneath the economy. And the only way that policy makers can provide that floor is through fiscal policy. Monetary policy has reached the end of the line. It’s now down to elected governments to decide what they are willing to do to prevent our economies from breaking. Let’s hope they act fast.