News & analysis

Monetary policy has been the global economy’s front-line of defence against the spread of COVID-19, with fiscal support only now beginning to trickle through outside of Asia with the recent announcements of the US emergency spending bill and Italy’s recent support package.

Monetary support has been in play in Asia since February 3rd when the PBoC cut repo rates and injected liquidity to soothe volatility, as onshore markets re-opened after the lunar New Year amid containment measures.

However, the spread of the virus outside of Asia sparked concerns that the global growth impact would no longer stem from a China specific slowdown and the resulting supply chain disruption.

The spread of the virus prompted markets to begin pricing in a global easing cycle with Jerome Powell’s Fed at the helm.

Even though monetary policy is a blunt instrument in supporting the economy against such an impact, it is much quicker to react due to its politically neutral nature.

Expectations were met last week when both the Reserve Bank of Australia and the Bank of Canada cut rates at their scheduled meetings, while the Federal Reserve dramatically embarked on the first inter-meeting rate cut since the collapse of Lehman Brothers in 2008 by cutting 50bp.

Despite the swathe of monetary support last week, financial markets are yet to be appeased.

Asset prices remain in freefall outside of Asia and money markets continue to aggressively price additional monetary stimulus in the near-term.

In the absence of large co-ordinated fiscal stimulus measures and a slowdown in the spread of the virus, monetary policy is likely to continue its role as the marginal support mechanism.

However, questions remain over how far monetary policy can go in a low-yielding environment. This is especially the case in areas where policy is already at or has breached the lower bound. In this light, speculation is rife that the ECB will continue the theme of cutting rates at their meeting this week, despite deposit rates already sitting deep in negative territory at 0.5%.

With this in mind, policymakers may have to become more creative and redefine the tools within their toolbox, shifting from conventional measures to support SME’s and thus the real economy.

Similar concerns arise with the Swiss National Bank as haven flows into the franc threaten to exacerbate the economic impacts of the virus on the domestic economy, while the Bank of England may also meet this week after the announcement of the fiscal budget as room to stimulate the economy is tight with rates currently at 0.75%.

 

V-SHAPED RECOVERY BEGINS IN CHINA

Chinese markets are trading as if the brunt of the virus and its ensuing economic damage has passed. The yuan is back below the psychological 7.00 level despite a consistently weaker fixing, while the CSI 300 index has recouped all of its losses to sit 2% higher YTD.

Measures by Chinese authorities were dramatic and are likely to have a large economic toll, but with further fiscal support aimed at infrastructure spending and targeted RRR cuts likely, the economy is expected to recoup much of its displaced activity in Q2.

The preliminary signs of both the economic impacts of the containment measures and the recovery in economic activity are already showing in the data.

The February PMIs from China carved fresh 16-year lows, with the Caixin measure of the service sector being of particular concern. However, the lack of a serious reaction in Chinese assets to the PMIs suggests that previous pricing changes have already braced markets for the economic damage.

The recovery in equity and FX markets is now consistent with proxies pointing towards the resumption of economic activity picking up to pre-virus levels.

Trading volumes in FX and construction materials are picking up, pollution levels are rising as one would expect with the resumption of industrial production and population flow, and staff availability measures are increasing – although a lack of transport data makes this harder to confirm.

Business resumption rates have been estimated at 70-80% and 62.1% as per Bloomberg Intelligence and Nomura estimates as of last week. This has been confirmed in recent data.

The National Development and Reform Commission recently stated that 79% of provisional projects have resumed construction, although while resumption rates have climbed, operating levels continue to be suppressed.

According to the Shanghai city government, 94.5% of larger industrial enterprises in the city had resumed production, but the overall operating rate was just 66% with only 64.6% of staff returning to work. The resumption in economic activity suggests that the Chinese economy is on track to start its V-shaped recovery at a time when developed economies begin to feel the pain of the virus.

However, the low production rates suggest further stimulus measures are likely in the coming weeks in order to speed up the return of growth to its pre-virus trend. Measures will focus on reducing the red-tape for employees returning to work, liquidity provisions and tax relief for SME’s and targeted RRR cuts, while a further 10bp cut to the one-year LPR cannot be ruled out.

 

Graph: Activity picks up in China as FX volumes and pollution indicators rise

 

FISCAL STIMULUS TAKES LEAD IN SOUTH KOREA

South Korea currently has the most coronavirus cases outside of China, with over 6500 people confirmed to have the virus and a death toll of 40.

Authorities are struggling to fight the virus’ rapid spread while dealing with the massive economic impact in the short-term. Mainland China is the second largest trading partner of South Korea after Honk Kong, with a market share of around 25% of total Korean exports.

The shock posed by the coronavirus is set to shrink Korea’s GDP by 1% YoY in Q1, while prospects for a moderate recovery reflects the slower-than-anticipated resumption of  Chinese activity and a weak domestic demand on the back of increasing prevalence of the virus.

The latest economic hit comes right after Korea was impacted by the US-China trade war and a separate bilateral conflict with Japan last year.

The Korean policy response has been concentrated in the fiscal space. The government recently unveiled an emergency extra budget of 11.7 trillion won ($9.8 billion) intended to help businesses hit by the outbreak.

The plan adds 8.5 trillion won to new spending, with 2.3 trillion allocated for medical support, 2.4 trillion for loans and subsidies to businesses and 3 trillion to support low-income families and jobs. Another 3.2 trillion won is destined to close the gap in missing tax revenues.

Recent reports also suggest that the government would be willing to call for a supplementary 15 trillion plan, roughly 0.7% of GDP, to build infrastructure and support small business, a similar extra-budget plan as in 2015 during the MERS crisis.

Even though attempts at implementing a sizeable fiscal stimulus would likely face opposition in parliament ahead of the April elections, the nature of the pandemic will likely expedite further spending bills. Some 10.3 trillion of the new plan will be funded by government bonds, raising the debt-to-GDP ratio to 41.2% from 39.8%, still one of the lowest among OECD members.

The ample fiscal response in South Korea has bought some time for the Bank of Korea to act.

The announcement by President Moon Jae-in on the extra budget spending came right after the G7 finance ministers called for coordinated cooperation and the Fed cut 50 basis points of interest rates. At the time, the BoK called for an emergency meeting the next day but, opposite to other Asian central banks, it refused to cut rates yet while monitoring signs of financial stabilization.

However, money markets are pricing in 31 basis points of rate cuts in the next 3 months and financial conditions can turn tighter as plenty of monetary support is released around the globe.

That increases the likelihood of emergency rate cuts in the upcoming weeks by 25 or 50 basis points, as the next BoK meeting isn’t scheduled until April 9th. Both the evolution of the coronavirus’ containment, and the prospects of further monetary policy action worldwide, will dictate the path for interest rates in South Korea, currently sitting at 1.25%.

The Korean won has recently recovered some 2.3% against the dollar, after dropping a 5.5% since the coronavirus outbreak in mid-January, and could be primed to rebound should authorities begin to rapidly control the outbreak.

ABE SAYS BOLD MEASURES WILL BE TAKEN IF NEEDED

The Japanese yen has soared nearly 6.5% over the last two weeks as coronavirus fears dampens global growth prospects and markets keep heavily shifting towards safe assets.

Haven demand for JPY has increased due to fierce market expectations of Fed interest rate cuts beyond the 50 basis points already shaved off; whereas the scope for further monetary easing from the Bank of Japan is remarkably limited in comparison.

The BoJ has made strong pledges to support the economy by means of all available instruments.

However, longstanding negative interest rates for short-term loans and further downside pressures on long-term bond yields beyond its 0% target restricts the size of any potential monetary stimulus.

The economic hit from the coronavirus outbreak adds to already weak growth prospects on the back of lagged effects of a tax hike in Q4, with analyst’s consensus already pointing to a technical recession in Q1.

Some speculation on the postponement of the Tokyo Olympics due should the coronavirus not be promptly contained would undoubtedly lead to a sharp slump in the Japanese economy in H1. Such a scenario would necessarily call for monetary policy action.

While closely monitoring coronavirus developments, the BoJ has extended support via short-term liquidity in repo-operations, with ¥500bn ($4.62bn) in loans to banks and a record ¥100.2bn in purchases of exchange-traded funds.

The bank also raised expectations for further asset purchases aimed at long-term growth although this remains a verbal pledge at the moment.

Interest rate cuts would probably be the last instrument to be considered as per its potentially lower effectiveness to target the most damaged sectors, but given the aggressive market pricing and the sharp currency appreciation, its likelihood is increasingly higher.

With such limited space for monetary support at present, fiscal policy will be needed. Japan already announced a sound stimulus package in December to counter the effects of the tax hike, but under recent circumstances, it could prove insufficient.

Abe’s adviser said the Japanese economy would need 5trn yen ($45 billion) of extra spending to respond to a severe hit from the coronavirus outbreak. Abe said Friday that he would take bold economic measures if needed.

 

FED SETS PACE AFTER INTER-MEETING RATE CUT

Despite the Federal Reserve’s inter-meeting rate cut last week, markets remain sceptical that this will be sufficient to soften the blow to the economy.

The emergency fiscal measures approved last week also did little to release US bond yields from the grasp of the latest risk-off move as only a minuscule amount of the overall fund is set aside for economic aid.

Since Tuesday’s announcement by Powell, swap markets have run with the idea that the Fed will embark on another 50bp cut in their March 18th meeting, marking a full point of easing in a month.

However, this alone still remains insufficient in the eyes of the market – US equity indices continue to flash red, while both swap and futures markets are implying the Fed will drive towards its effective zero lower bound by the end of the year.

With this in mind, and the economic toll of the virus on the US economy still unknown due to it still developing in its juvenile stages on the mainland, the 10-year treasury yield continues to fall to record lows with other tenors also breaking records set in 2008.

The emphasis is now on how much this coordinated stimulus package, both in the US and in the G7, can mitigate the economic impacts and whether the US will embark on fresh quantitative easing in order to refrain from lowering rates as aggressively as markets are pricing. T

he past year has highlighted that central banks globally are not only data-dependent but are also bringing risk mitigation methodologies into consideration when setting policy. This is only going to increase in prevalence as more and more central banks approach the threshold for negative rates and with the jury still out on their relative success.

 

Graph: US Yields hit record lows upon coronavirus fears

 

BANK OF CANADA MAY HAVE LESS ROOM TO CUT THAN FED

The Bank of Canada followed the Fed in cutting rates by 50bp last week and are likely to lag the pace of the US central bank going forward as Jerome Powell remains on track to deliver another substantial cut this month.

We argue that the floor to the Bank of Canada’s rate is likely higher than that of the Fed’s, as things currently stand, due to the vulnerabilities in the Canadian economy. High levels of household leverage, elevated inflation levels, and rising housing prices may keep the Bank of Canada in check in the hare and tortoise race.

The latest swap pricing seemingly confirms this view. Speaking in Toronto a day after the BoC rate cut last week, Governor Poloz outlined that the Governing Council had a pre-existing easing bias as poor economic growth in 19Q4 threatened to spill over into 20Q1.

This took some of the shine off the rate cut itself, suggesting that part of the 50bp move was already baked into policymakers’ judgement, whereas for the Fed the coronavirus arguably forced the cut as a whole.

Further rate cuts by the Bank of Canada in April are likely, with 25 basis points returning the overnight lending rate to 1%; the level it was at when Poloz’s term started in 2013.

The recent downturn in global growth and rising risks of coronavirus induced recessions not only makes monetary policy decisions hard but government policy also. The race to replace Poloz is still wide open and the current environment seemingly adds to the difficult task imposed on Prime Minister Trudeau and his Finance Minister.

 

 

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