What is needed to calm the markets?

Last week, we wrote that the market’s recovery would depend on the speed and effectiveness of the governments’ responses ( “Navigating the uncertainty”). On Sunday, the US Federal Reserve (Fed) cut rates by 100 basis points to zero and restarted its purchases of Mortgage Backed Securities (MBS) and Treasuries. The Bank of Canada (BoC), Bank of Japan (BoJ), European Central Bank (ECB) and the Swiss National Bank (SNB) have also offered USD liquidity swap lines with extended duration and cheaper rates. The BoJ has since followed the Fed’s unexpected rate cut with a massive increase in asset purchases. The Japanese central bank will increase its annual purchases of Exchange Traded Funds (ETFs) from ¥6 trillion/year to ¥12 trillion/year, surpassing expectations.

The Fed’s easing together with the co-ordinated currency swaps of major central banks seeks to dampen the funding stresses recently observed in the Treasury, MBS and currency markets.

As mentioned in our earlier note, global central banks today do not have as much policy room as they did in previous market cycles to buffer against an economic shock. Nevertheless, the actions of the G7 central banks to date demonstrate a willingness to take pre-emptive steps to front load easing measures, safe guard credit flows to companies and support the economy.

We believe that three steps are needed to stabilise the markets – 1) Control the outbreak 2) Inject liquidity and 3) Boost demand. While each of these steps is important, the sequencing matters. The global central banks’ easing measures have focused on steps two and three, but step one is the wild card for markets. Investors are currently more concerned over how long demand will remain subdued and the accompanying economic fallout. Meanwhile, steps two and three help provide liquidity but do not solve the root cause of the growth shock. Investor sentiment and markets are likely to remain jittery until we see evidence that the outbreak is being contained.

A peak in daily new cases is the key focus and two actions are required. There first needs to be a pause in daily social activities to help limit community spread. Next, large-scale and quick coronavirus testing must be made easily available. If governments find it challenging to pause activities, then Korea’s speedy testing would be the model to follow. At drive through testing facilities in Korea, fluid samples are collected from passengers and test results are returned in a matter of hours. This helps to reduce contamination exposure and overcrowding at hospitals. Mass testing can help identify carriers of the virus who can then be quarantined. The tests can also help spot clusters within the community which can in turn be targeted as “containment zones”.

Over in the US, the Centers for Disease Control and Prevention have urged organisers to cancel or postpone in-person events with 50 or more in attendance throughout the United States for two months. Mayors of various states including New York and Los Angeles have since asked nightclubs, movie theatres and concert venues to close, with effect from March 17. Restaurants, bars and cafes would only serve take-out and delivery in order to limit close interactions. While the “pause” seems to be unfolding in the US as well as in other developed countries, the infrastructure needed for mass testing is still being put in place. Not just in the US, mass testing is currently limited in many developed markets. See Fig. 1.

Fig. 1. Total COVID-19 tests performed per million people¹

If the developed markets increase the pace of testing, we may see the number of daily new cases peak in about two weeks after a “pause” has been initiated, similar to the pattern observed in China and Korea. Meanwhile, the situation in densely populated emerging markets such as India, Brazil and certain countries in Asean is also perilous as the public healthcare systems in these countries are likely to face challenges in testing, tracing and treating the outbreak.

Monetary policy response on its own will be insufficient to stabilise market sentiment under current conditions. The markets need to see government authorities take decisive steps to effectively control the spread of the virus, and at the same time introduce measures to help real businesses tide through the transitory disruption. This will prevent a liquidity squeeze from turning into a solvency issue.

We do not think this is a repeat of the 2008 Global Financial Crisis (GFC). The integrity of the global financial system is not being called into question. The virus outbreak in the US and Europe will have a one-off negative drag on their economies as long as effective containment measures are introduced. These measures will help economic conditions normalise in the second half of 2020. With effective containment measures, the monetary easing and fiscal firepower that have been deployed to combat the growth shock are likely to remain in place for a considerable period, even after the effects of the virus fade, thereby providing support to asset markets.