Baptism by Fire

The high-frequency economic data that inform investment and policy decisions are too dated to be of much significance now.  The muted response to the robust US employment data illustrates this point.  Events are moving quickly.  The containment of the coronavirus has failed, and it is now reported in more than 90 countries.  

The precise economic impact may be unknown, as former Treasury Secretary Summers noted in a recent op-ed piece in the Washington Post that argued against the Fed cutting rates, but policymakers and investors do not need such precision.  The direction of the shock is clear.  The magnitude is less known, but a cursory look suggests the near-term economic impact is likely more moderate to severe rather than minor. 

Trillions of dollars of market capitalization have been lost in the past couple of weeks.  Financial conditions have tightened.  US, UK, and Australian bond yields have never been lower.  The US 30-year bond yield has never been below 2%, and now it is below 1.5%.  German Bunds yields are near record lows of near minus 75 bp. Investors seem to be concluding that the Federal Reserve is heading back toward the zero-bound.  At the low point in the Great Financial Crisis, the fed funds target range was 0-0.25%. 

Fed officials have been unanimous in their disdain for negative interest rates.  Even if the Fed respects the zero-bound, many observers warn that bond yields could turn negative.  After walking through Alice-in-Wonderland's looking glass of negative interest rates, it is difficult to know the new rules and relationships.  The sample size and duration may also not be enough to draw hard and fast conclusions.   That said, thus far, no country has seen bond yields go negative without first reducing the policy rate below the zero-bound.  Also, no country with a current account deficit (savings < investment) below zero.  The UK 10-year yield has fallen below 25 bp and may challenge this hypothesis.  

The debate among market participants and observers about whether Covid-19 is a supply or a demand shock is mostly beside the point.  There are significant elements of both.  The issue is that policymakers feel compelled to respond. several countries, including China, South Korea, Japan, Italy, and the US are providing new government funds. Germany's infamous "black zero" fiscal principle may be challenged by the public health crisis. Still, the CDU, which is in the middle of a leadership challenge to ostensibly replace Merkel next year, has pushed against hopes that it will be abandon in any broad, meaningful way.  Even the Social Democrat Finance Minister seemed to favor a limited, temporary, and targeted effort.   

The UK's budget will be unveiled next week (March 11).  Prime Minister Johnson is committed to eschewing the fiscal straightjacket introduced by Cameron/Osborne, even before the outbreak of the coronavirus.  In this, Johnson and Trump represent part of their country's center-right that does not embrace fiscal austerity.  It may be tempting to put Japan's Abe in the same camp, but the LDP, which has governed for more than 50 years with only relatively short and ill-fated exceptions, rarely embraced fiscal austerity in any meaningful way, and its debt/GDP of over 200% is evidence, even if the central bank now owns more than half and the sales tax was hiked last year.    

Not only is it Johnson's first budget, but it will be presented by the new Chancellor of the Exchequer Sunak. He took the helm unexpectedly when his predecessor (Javid) resigned rather than dismiss his top deputies and apparently see his relative independence compromised.   The need to blunt the economic impact of the virus may impact the budget details on the margin.  Johnson is looking to fulfill his campaign promises, including more funds to the north, raising the income threshold for National Insurance contributions, and some more protections for gig workers.  While the thrust sounds almost like social democrats, there is a limit.  The Tories will not support a wealth tax or mansion tax, though some loopholes (tax breaks that benefit high-income earners) could be closed.  Local reports point to the Entrepreneurs' Relief, as a possible candidate, especially after Johnson was critical of at the beginning of the year.    

There are two other considerations.  First, the overall household taxes may still rise as the local councils have scope to raise taxes too.  Second, Johnson and Sunak will get another bite of the apple.  Another budget will be presented in the fall.  By that time, negotiations with the EU will be clearer too.  Johnson has threatened to walk away from negotiations if there is no movement toward his goal of a Canada-like free-trade agreement by mid-year.  There is some thought that the Covid-19 crisis may soften both sides from the brinkmanship tactics, but this has yet to be seen. 

The Reserve Bank of Australia, the Federal Reserve, and the Bank of Canada, among the major central banks, have cut rates.  The European Central Bank, the Bank of England and the Bank of Japan will have their opportunity soon.   Bailey, who will replace Carney as Governor of the Bank of England later this month and will chair the next MPC meeting, has already struck a cautious chord.  He pushed against speculation that the BOE would follow the Federal Reserve with an inter-meeting rate cut. 

However, before getting to the BOE and the BOJ, the ECB has a turn.  It will be Lagarde's first difficult decision since taking the post last October.  Before leaving, Draghi led the ECB to cut rates, resume asset purchases, and offer a targeted long-term refinance operation.  The  ECB was unable to normalize monetary policy after the double hit of the Great Financial Crisis and its own sovereign crisis. 

The structural reforms that Draghi and others pleaded for were not delivered in adequate breadth and scale.  To use a timely analogy, this left the eurozone without a healthy immune system to fend off another shock.  The timing and nature of the shock are often unpredictable, but given the historical record, they are inevitable.  

A few countries in the euro area may contract in Q1.  Inflation expectations are imploding.  The need for fiscal support, which both Draghi and Lagarde have urged, has rarely been more obvious than now, but refusing to address the current crisis to force governments to respond does not appear to be in central bankers' DNA.  Scorched earth strategies would seem to violate the ECB's mandate.

So, if the ECB is to act,  even if it is arguably not as effective as fiscal policy in the current setting,  what is it to do?  There are three levers: rates, asset purchases, and TLTRO.  The current key policy rate, the deposit rate is set at minus 50 bp.  It is not clear what cutting it by another 10 bp will accomplish.

A rate cut may not be directly impactful, but it could allow bond yields to fall further.  It could also impact the terms of the existing TLTRO facility.  The ECB is currently buying 20 bln euros of mostly government bonds a month.  This facility can be expanded and judging by some official comments, it might be less controversial than another rate cut.  According to surveys, this is seen as the most likely action, while respondents were more divided on renewed asset purchases.  

Lagarde's comments last week mentioned a targeted response.  Many observers took this as s a reference to the TLTRO facility. However, in the context, we understood it to signal no intention to follow the Federal Reserve's inter-meeting cut with one of their own.  A rate cut is a broad instrument, not targeted.  That said, the TLTRO seems to be among the least controversial of the ECB's unorthodox policies.  The terms of the existing facility could be tweaked, but the banks are to submit their bids for the third tranche of the third TLTRO shortly.  Instead, the ECB could launch another facility—the Daughter of Targeted Long-Term Refinancing Operations that encourages banks to lend to small and medium-sized businesses.     

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