April Monthly

In March,  the G10 and many emerging market countries, governments, and central banks unveiled large emergency measures.  The motivation is to blunt the economic impact of the novel coronavirus that has seen more than two billion people around the world have their movement restricted. Large swathes of the world's economy have shut down.  The nature of the shock means that the first countries to push its companies to re-start, and especially export-oriented countries, such as China, may experience a second-round effect as demand in other countries has not returned.

As April begins, the situation in most countries continues to deteriorate rapidly, and both the duration and magnitude of the economic crisis are difficult to fathom.  As an initial stab, economists are penciling 5%-10% quarter-over-quarter contractions in Q2 for high-income countries. Growth is expected to recover with a strong second-half rebound.

Governments moved relatively quickly in announcing different types of support for workers, households, and businesses.  Some common elements include direct payments to individuals, extending or deepening unemployment benefits, a focus on small and medium-sized companies, including the self-employed, as well as tax deferment.   In several European countries, including the UK, the government will subsidize the wages of those employees who have their hours reduced without being made redundant.  The emergency has gotten Germany to eschew its fiscal prudence with a debt-funded stimulus plan and a  large bond-guarantee program. Several countries will take equity stakes in some companies that need assistance.     

Central banks moved aggressively to ease the disruption in the capital markets and financial institutions.  Within the G10, the dollar-bloc countries, including the US, brought policy rates to the zero-bound.  Those central banks that already had negative rates (ECB, BOJ, and SNB) were reluctant to cut them further.  Asset purchases programs were initiated and expanded, such as the Bank of Japan's doubling the size of its ETF purchase program.  The ECB launched a 750 bln euro bond purchases program for which the previous self-imposed restrictions (e.g., issuer limits) will no longer apply.  It is more powerful and flexible.

The Federal Reserve announced open-ended Treasury and mortgage-backed securities purchases.  It also re-activated several of the facilities it had created in the Great Financial Crisis to support commercial papers, primary dealer lending, and asset-backed securities.  In the last two weeks of March, the Federal Reserve's balance sheet jumped by more than a trillion dollars.  For the first time, the Fed offered a program of support for corporate bonds and local government bonds.  Another initiative to more directly help small and medium-sized businesses is expected to be announced shortly.

The Federal Reserve made dollar swap lines cheaper (25 bp over OIS), more accessible, and extended them to a new group of (nine) central banks outside of the handful (BOJ, BOE, BOC, SNB, ECB) or have permanent swap facilities.  It helped reduce the strain in the cross-currency swap market, a widely-used channel to shift liquidity from one currency to and another.  At the peak usage in 2009, the swap lines were used for more than $600 bln.   

The Fed also announced a repo facility for foreign central banks, who could repo their Treasury bonds instead of selling them to raise dollars.  Foreign central banks liquidated nearly $110 bln of Treasuries from their custodial account at the Federal Reserve in March (leaving them about $2.9 trillion).  The declared purpose was to give central banks with Treasury holdings a recourse to selling them as a way to help stabilize the market.  

It is too soon to know if the swaps take pressure off the dollar in the spot market as well.  Some of the dollar's dramatic gains in March were surrendered ahead of the month, quarter, and for some, the fiscal year-end.  The repo facility is new, but if central banks did not want to sell the Treasuries they did, they could have conducted repos with commercial banks.  The dollar begins the second quarter having pared its earlier gains over the last week and a half of the quarter.   A weaker dollar is consistent with easier financial conditions globally, and this is, no doubt, the desired direction, from that vantage point.  Yet none of the other G10 countries outside of Norway have expressed the desire for a stronger currency.   

The high-frequency economic data will be dreadful, but this is well appreciated.  Such fears contributed to the violence of recent moves in equities, interest rates, and the dollar.   April will be about the implementation of the official efforts.  This is the curve of the ability of officials to meet expectations.  It is about being able to minimize the liquidity issue from morphing into a solvency crisis.  The other curve that will command attention, of course, is about COVID-19. The official response is meant to be calibrated to some estimate of the need.  That need, in turn, seems to assume that by the end of April or early May, social distancing measures on average can be relaxed in Asia, Europe and North America.  As winter season returns to the Southern Hemisphere, the progress of the contagion will be closely monitored.    

  

Dollar:   The federal government and the Federal Reserve unleashed powerful measures to help blunt the economic and financial disruption.  It did not allow its trillion-dollar a year deficits to prevent it from a dramatic jump in borrowing.  Washington hopes payments to households can begin in April or early May.  The Fed is unwriting large segments of the capital markets through its different lending facilities and, in effect, purchase a significant amount of the new Treasury supply. Many of those that argued that the expansion of the budget deficit and the Fed's balance sheet in 2008-2009 would spur inflation are making their case again.  Yet, like then, the deflationary forces seem set to overwhelm them.  A good part of the cash payments will not be used to purchase a limited supply of goods and services but will likely be used to pay for previous consumption (service debt and bills) or saved.  The weekly jobless claims provide the closest to a real-time metric of the economy.  Access has been liberalized, and the duration extended.  Initial claims rose to a record of near 3.2 mln in the week ending March 21. Continuing claims peaked in 2009 around 6.6 mln.  A multiple seems likely in the period ahead.  There continues to be speculation that the Fed will adopt yield curve control (targeting a note or bond yield in addition to fed funds), but this does not seem imminent.  Fed officials have consistently dismissed the likelihood of adopting a negative policy rate. The short-dated Treasury bills briefly implied a negative year, but this was a reflection of the distortion in the markets and not a function of policy per se.  

Euro:  European national leaders and the ECB have made robust responses to the crisis.  There has been a recognition that what is not acceptable in normal times is allowable in an emergency. The ECB's Pandemic Emergency Purchase Progam (750 bln euros) without being bound by the capital key (roughly proportionate to GDP) or issuer limit (33%) gives ECB officials greater discretion than in the sovereign debt crisis. Yet there appear to be some lines that Europe is not ready to cross, like common bonds.  While the obligations of the European Investment Bank (EIB) and the European Stabilization Mechanism (ESM) are jointly shared, the creditors, led by Germany, remain reluctant to support a common inter-governmental bond.    Nor is this, as some have suggested, a Hamiltonian moment for EMU. There is no assumption of state (national) debt by the federal government (shared among countries in Europe).  A majority of EMU members want a joint bond, but the compromise may be a line of credit at the ESM with light conditions attached.

(end of March indicative prices, previous in parentheses)

Spot: $1.1030 ($1.1025) 

Median Bloomberg One-month Forecast $1.11 ($1.1045) 

One-month forward $1.1065   ($1.1047)      One-month implied vol 9.3%  (6.8%)    

Yen:  Although Japan was one of the first countries outside of China to detect the virus, without many social measures, outside of closing schools, it had at least as of late March, appeared to experience low levels of contagion.  Nevertheless, the economic hit will be substantial.  The growth seemed to have begun to rebound about a 7.1% annualized contraction was recorded in Q4 19 (due to the tax hike and tsunami disaster.  After passing the FY20 budget in late March, with some funds earmarked to the Covid-19 crisis,  the Abe government is expected to announce a large spending bill in early April that is expected to be at least 10% of GDP.    The Olympics have been postponed, and some government money may be needed.  Japanese financial institutions use the dollar-funding markets extensively to support their purchases of dollar-denominated assets and derivatives.  Japanese banks have drawn most heavily on the official swap lines.  However, even as Japanese banks' demand was strong, the dollar's ascent against the yen was not snapped until a broader pullback was underway, after the passage of $2.2 trillion package by the US Congress.  

Spot: JPY107.55  (JPY107.90)      

Median Bloomberg One-month Forecast JPY107.50 (JPY107.90)     

One-month forward JPY107.50  (JPY107.50)    One-month implied vol 13.2% (8.9%)  

Sterling:  The British pound was rocked by recent developments.  Each of the last three weeks in March saw more than a ten-cent range against the dollar.  One has to go back to the flash crash in October 2016 and the referendum itself in June 2016 to get a monthly range of a dime. The lack of liquidity likely contributed to its dramatic price swings.  Sterling fell to a 35-year low on March 20 (~$1.14), rebounded to $1.25 before the end of the month.  The government announced several fiscal initiatives that could be worth around 7% of GDP.  The Bank of England slashed the bank rate to 10 bp and resumed its asset purchase program (GBP200 bln  ~9% of GDP).  It is becoming increasingly likely that the UK will need to extend its stand-still transition period before leaving the EU at some point.  It may be politically controversial, and additional funds may be required.   Fitch downgraded the UK at the end of March to AA- with a negative outlook citing both the three-fold increase in the deficit and uncertainty over its future trade ties with the EU.  It is the lowest of the three main rating agencies (S&P AA+ and Moody's Aa2 equivalent to AA), and the market showed little reaction.

Spot: $1.2430  ($1.2825)   

Median Bloomberg One-month Forecast $1.2455 ($1.2870) 

One-month forward $1.2430  ($1.2835)   One-month implied vol 14.5% (7.3%)

  

Canadian Dollar:  The COVID-19 crisis and collapse of oil prices sent the Candian dollar reeling in March, falling 10% at its lows.  The US dollar surged from around CAD1.3315 on March 2 to almost CAD1.4670 on March 19.  The price of WTI fell by nearly 75% in Q1 and more than 50% in March alone.  The central bank slashed its overnight rate to the zero-bound (25 bp) and begun a formal asset purchase program that includes government bonds and commercial paper.  It has also moved to provincial and municipal debt.  The national housing agency will buy C$150 bln of mortgages from banks.  The government has unveiled some broad measures, including, in its latest version, 75% wage subsidy and $2000 a month for up to four months to those who lose their job due to the virus shutdowns.   In early April, an industry-specific aid package is expected to be unveiled with oil and airlines the focus.   

Spot: CAD1.4065  (CAD 1.3405) 

Median Bloomberg One-month Forecast  CAD1.4025 (CAD1.3330)

One-month forward CAD1.4060    (CAD1.3410)    One-month implied vol 11.7%   (6.2%) 

Australian Dollar:  The Reserve Bank of Australia became the first G10 central bank outside of Japan to adopt a yield-curve control strategy.  It targeted the three-year yield at 25 bp, the same as its cash rate.  The RBA also launched a substantial term-funding facility.  The government has announced spending measures, which include cash payments and support for small and medium-sized businesses worth about 5% of GDP.  The Australian dollar was falling before the crisis hit, and its losses accelerated in March.  It spiked to a low near $0.5500 on March 19, off about 15.5% on the month before rebounding.  It finished last year, around $0.7020.  The Aussie's rolling correlation to gold (on a percent change basis) rose above 0.55 for the first time in five months.    

Spot $0.6145 ($0.6615)       

Median Bloomberg One-Month Forecast  $0.6165 ($0.6575)     

One-month forward $0.6145  ($0.6520)     One-month implied vol 18.1% (9.4%)   

Mexican Peso:  The Mexican economy contracted in all four quarters in 2019, and the economic consequence of the COVID virus and the dramatic drop in oil prices will hit it hard.  The country's three main sources of capital, tourism, worker remittances, and oil revenues, have dried up. The government and central bank have been slow to respond to the coming crisis.  The overnight target rate was cut by 25 bp in mid-February and 50 bp in March, but at 6.5%, it remains among the highest in real and nominal terms.  The peso was the weakest currency in the world in March, losing nearly 16% against the dollar.  S&P downgraded Mexico's sovereign rating to BBB, in line with Fitch's decision last year, and retained a negative outlook.  That leaves Moody's as the outlier at A3 (AA-).  Additional rate cuts are likely, and further fiscal measures will be needed.  The state oil company's finances are being stressed and the issue may come to a head for the government in April as the price of insurance on its bonds (credit default swaps) tripled in recent weeks.  

Spot: MXN23.77 (MXN19.6440)  

Median Bloomberg One-Month Forecast MXN23.46 (MXN 19.5030)  

One-month forward MXN23.81 (MXN19.6650)     One-month implied vol  33.7%  (13.6%)

Chinese Yuan:  Two months after China was locked down, the world's second-largest economy is re-starting, but facing weaker global demand.  China has not announced a large fiscal stimulus package yet, but a new initiative is expected shortly, and state governments have been allowed to borrow more.  The People's Bank of China has not been particularly aggressive, but a discount rate cut and an additional reduction in reserve requirements are expected.  There is some concern that Chinese corporates have about $120 bln in dollar-debt coming due this year, but this is a perennial concern, and the strain seems manageable.  The yuan weakened by about 1.7% in March, but officials seem to be managing a fairly steady exchange rate.   

Spot:  CNY7.0820  (CNY6.9920)

Median Bloomberg One-month Forecast CNY7.0760 (CNY6.9940) 

One-month forward  CNY7.0790 (CNY6.98)    One-month implied vol  5.7 (3.8%)

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