The Economic Tsunami that has Begun and the Drive for Cash

With swarms of locusts in Africa and the Middle East and a particularly virulent virus spreading around the globe, the coming crisis may feel like the end of days. An economic tsunami has been unleashed. A consensus appears to be emerging among economists of the largest contraction in global GDP in a generation. Separately, but partly related as well, oil prices have cratered to nearly $20 a barrel last week, the lowest in 18-years. Central banks are trying to head-off or mitigate the financial shock waves.

To be sure, the response by governments and central banks has been evolving as the magnitude of the challenge has become clearer. Rate cuts and asset purchases have been widely announced, though notable, countries with negative rates have not opted to cut them deeper. Many of those that were above the zero-bound, like the US, UK, Australia, New Zealand, Canada, and Norway moved aggressively. Liquidity injections were made, and asset purchase programs were re-launched or, as in the ECB's case, dramatically extended. In two emergency moves, i.e., between meetings, the Fed went from the economy and policy were in a "good place" to 125 bp rate cut, $700 bln long-term asset purchases, and new facilities to support commercial paper issuers, money market funds, and primary dealer lending.

Fiscal policy, too, has been brought into action. Increasingly, global leaders, including in the US, are going to war-footing. In this emergency, self-imposed constraints are being re-thought. On top of a trillion dollars a year deficits before the health crisis, the US is putting together a package of around $1.2 trillion. Two significant components stand out, direct payments to individuals (which ultimately could be means-tested) and aid to impacted industries. There may also be a payroll savings tax cut, but faces bipartisan opposition (it is regressive, shifts problem to underfunding social security, and there are arguably more effective ways to boost consumption). Another package that includes direct assistance to state and local governments is likely to be required at some point.  

When everything is said and done, officials are responding relatively quickly to the emerging economic and financial fallout.  The benefit of the 2008-2009 experience and response is helping in many respects. Many non-conventional tools had been developed and are being dusted off.  Yet the magnitude of the problem is greater than in past crises, and some measures of volatility have already outstripped the high seen a decade ago.

A significant part of the economy is shutting down. Consider that the hospitality industry, broadly defined to include air and ground travel, hotels, restaurants and bars, casinos, sporting events, performing arts, is about 14% of the US GDP. Auto production is coming to a standstill in the US and Europe. It is around 3.5% of US GDP. There may be some substitution that takes place; grocery and liquor sales rise. Still, as a ballpark effort to think about the coming economic downturn, at least 20% of the economy may be zeroed out for a bit. Hospitals and the medical industry may be one of the only sectors that grow, and health care is about 18% of the US economy.

A small taste of what is to come was seen in the US weekly initial jobless claims. The 70k jump in the week through March was the largest non-weather related spike in percentage terms. Many economists were surprised by how quickly the layoffs hit, but the report covering this week (March 26) is likely to surge further. Weekly jobless claims peaked during the Great Financial Crisis at 665k. We should be prepared to see this surpassed by several magnitudes in the coming weeks. Reports indicate that around 500k people in Canada sought unemployment compensation last week, compared with 27k in the year-ago week.  

Returning to that simplified look, the hospitality industry employs nearly 10% of the US workforce or roughly 13.8 mln full-time equivalents. When the tech bubble popped, the unemployment rates peaked (2003) near 6.3%. During the Great Financial Crisis, it reached 10%.  Unemployment was at 3.5% in February.  Those levels are most likely to be surpassed.  

Much of the high-frequency data has been superseded by events. The week ahead will see the flash PMI readings. They will begin giving a sense of the coming economic hit. In February, the eurozone composite PMI was 51.6 (manufacturing was still below the 50 boom/bust level at 49.2). A reading in the low 40s would ought not to surprise. The US composite was at 49.6 in February, the lowest in years. The question now is the magnitude of the decline. The NY and Philadelphia Fed surveys point to a dreadful number. The UK composite PMI in February was at 53.0, It had risen sharply from 49.3 in November and December after the election. Japan's composite PMI had been recovering from the October tax hike and tsunami to poke back above 50.0 in January before falling to new lows (47) in February, perhaps the Lunar New Year effect and the preliminary hit from China.  

II

The dollar soared last week, rising no less than 3% against all the major currencies. Norway's krone was an outlier. Its nearly 14% decline was more than twice as large as the second weakest, the Australian dollar (-6.5%). Threats by the central bank to intervene, and counter-intuitively, an unexpected 75 bp rate cut ahead of the weekend (bringing the deposit rate to 25 bp) seemed to help it steady briefly, but as the stock market and oil chopped lower, the krone stability proved illusory. 

There are two broad explanations of the dollar's surge. The first and seemingly, the main view is that the dollar is a safe-haven. A recent Wall Street Journal headline captured this idea: "Dollar Surges as Investors Seek Shelter."  There is a sort of commonsense appeal.  In this incredibly uncertain and unprecedented time, people, companies, and financial institutions are hoarding dollars. The US remains the world's largest economy, the deepest capital markets, and despite the knocks, remains the most important currency in the world, the numeraire. 

The other explanation digs deeper into the role of the dollar in the international flow of capital and goods and services. The US currency is often borrowed in financial transactions to purchase other assets. When the assets, like stocks, bonds, or even gold, are sold, the dollars have to be repaid. It is a fixed amount of dollars that have to be repaid regardless of how the asset price, including the foreign exchange translation, has been impacted. Many supply-chains are financed with dollars, and as trade slows, those dollars will be returned, in effect. Depending on how it is measured, there is between $12 trillion and $14 trillion in dollar-denominated liabilities.  

It is understandable why US banks are reluctant to lend. Their sources of revenue, like advisory, underwriting, M&A, have dried up, and many small and medium-sized businesses will need some kind of relief (to avoid allowing what begins off as a liquidity issue turning into a solvency issue).  Larger enterprises are drawing down their credit lines.  

Several different channels can be accessed for dollar funding. During the Great Financial Crisis, the Federal Reserve offered swap lines to numerous central banks that would then auction them to the foreign banks to allocate. The swaps lines worked then and were one of the under-appreciated crisis-mitigating tools.  he Federal Reserve made several of the swap lines permanent. However, the premium was not particularly attractive (overnight index swaps plus 50 bp), and swap lines were largely dormant. 

The Fed has made three moves in the past week. First, it cut the premium to 25 bp and offered a longer-duration facility (84-day funds complementing the seven-day swap). This applied to the six banks for which swap lines were permanent. Second, the Federal Reserve offered temporary swap lines to a wider-range of countries, including several emerging markets, such as Mexico, Brazil, Singapore, and South Korea. Third, before the weekend, the Fed offered the central banks with permanent swap lines (ECB, BOJ, BOE, BOC, and SNB) a temporary daily rather than weekly seven-day swap auction. 

The idea is that the provision of those dollars will satisfy the demand, which arguably was amplifying the disruption. While for the euro, yen, and sterling cross-currency swaps normalized, it did not alleviate the immediate upward pressure on the dollar. Unlike during the financial crisis, the problem now is not counter-party risk but the access to cash dollars. The dollar made new highs against the euro, yen, sterling, and Swiss franc after the swap lines were drawn upon last week.  

If swaps do not work to ease the pressure, additional steps on the escalation ladder may be necessary. Both the Reagan-Volcker dollar rally in the first half of the 1980s and the Clinton-Rubin rally of the second half of the 1990s ended with coordinated intervention. Unlike the previous experience, other major central banks do not appear nearly as concerned about currency weakness.  

Several central banks from emerging market countries have intervened directly and through offering fx swaps or options themselves. The Philippines closed its markets for a couple of days last week, and it still fell 17.5% for the week, which turned out to be among the worst in the world. Unilateral action is another rung in the escalation ladder, but its effectiveness is questionable, after a surprise or headline effect. It is tempting for some officials, like Norway's Norge Bank to verbally threaten intervention, it might work once briefly, but it loses the element of surprise and tempts speculators to "ask to see the money." Also, in Norway's case, the low risk of intervention outside of its time zone may encourage speculation against Nokkie after its markets close.  

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There is great uncertainty as we, the entire world, deal with something, and on a scale that is unprecedented. It is frankly frightening. In this difficult time, I find it comforting to recall historical examples where, after a slow beginning, incredible progress was made. It is almost as if Hemingway's description of how bankruptcy happens is applicable to this experience: gradually and then suddenly. The North in the US Civil War, the US in the Great World War, and in the race to the moon, are specific American examples that come to mind, but of course, there are countless examples from all over the world.   

The large machinery of large modern organizations may take a bit of time to get going, but then they do. Incredible results are possible, and it does appear that over the past week or so,  as the magnitude of the challenge has become clearer, the large machinery is beginning to turn. Prior views and convictions are being questioned, and the previous redlines, like Germany's black zero budget, will be overcome by the need for bold action. Broad swaths of the world are going on war-footing to combat the virus, some civilian capacity will be re-tooling to make ventilators or masks, to developing vaccines all in numerous countries, and beginning the serological work of immunity testing. 

Of course, statecraft continues as national interests are pursued, and businesses and investors have to consider the future, but rarely has there been such a global effort driven by a single purpose. In this dark time, do not discount human ingenuity and the power of lifeboat ethics.   

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