Central banks shot their last big bullets. Markets sold off anyway.

Welcome back to the world of 10% daily moves in global equity markets. There was a lot of news over the weekend, none of which was particularly unexpected.

Coronavirus cases in Europe and North America continue to accelerate. As containment efforts ramp up, so too do the economic consequences from them. It looks increasingly likely that the global economy will fall prey to a technical recession in the coming months—one that began in March and carries over into at least the early part of the second quarter. This shouldn’t be viewed as a heroic or troubling forecast—central bankers, economists, and yours truly are all reacting to virus developments and marking our forecasts to market.The MSCI World Index has declined 18% (in CAD terms) as of Feb. 191, while in the U.S., the 22.2% decline has effectively already discounted a mild-to-moderate economic recession.

The Fed responds

Enter the policy response. On Sunday, the U.S. Federal Reserve (the Fed) brought out the bazooka, announcing its second emergency move of the month—and it was a BIG one, with a battery of policy measures

  • A 100-basis-point reduction in the federal funds target range to the zero lower bound
  • US$700 billion in asset purchases of Treasuries and agency mortgage-backed securities (MBS)
  • New term dollar funding facilities with central banks of Canada, Switzerland, Japan, Eurozone and UK, offering U.S. dollars weekly in each jurisdiction with an 84-day maturity, in addition to the one-week maturity operations currently offered
  • Enhancements and guidance to promote liquidity (discount window, capital buffers, intraday credit)2

It’s possible that the selloff Monday morning suggests investors viewed these emergency changes as a troubling sign—the proverbial worry that the Fed might know something we don’t know. That's not how we see it. Look no further than the lack of economic projections accompanying the decision. We believe the Federal Open Market Committee (the FOMC) thought there was WAY too much uncertainty from the virus to put a gross domestic product number down on paper right now.

The Fed's aim: Preserve liquidity

What we know is that this, and all recent moves by the Fed, have been aimed at keeping liquidity in the US economy, banks and markets. They were not considering what the U.S. equity market reaction would be. And for what it’s worth, fixed income pricing and the consensus of Wall Street economists had already evolved to expect the Fed to cut interest rates to zero this week. It’s hard to imagine stocks would have rallied on a smaller rate cut or less quantitative easing.

The one sliver of disappointment here is that the Fed has not yet launched a commercial paper funding facility like it did in the crisis. In 2008, the Fed—through its special purpose vehicle—was the buyer of last resort for the short-term liquidity needs of non-financial companies. With liquidity needs and market disfunction prevalent again today, such a program would be a welcome addition.

One final point on monetary policy: Unsurprisingly, following a big move from the Fed, other global central banks have been quickly announcing easing measures of their own. The Bank of Canada cut rates twice in the past few weeks, to 0.75%. Japan, Australia, South Korea and New Zealand have also already eased. We expect more to come this week.

As we’ve written about previously, fiscal policy is better suited to provide targeted, timely and material assistance to affected households and businesses. For example, we were encouraged by reporting over the weekend that U.S. Treasury Secretary Steven Mnuchin and House Speaker Nancy Pelosi have been in talks to provide assistance to airlines, cruise lines and the hotel industry. These aren’t big steps (yet), but the ball is rolling in the right direction.

Putting market volatility in perspective

While the catalyst for this market selloff is unusual, extreme periods of market volatility are not, looking across decades of experience in U.S. and global financial markets. It’s important not to lose sight of the fact that this uncertainty is precisely what compensates investors in equities and credit markets to command a higher risk premium and expected return over government bonds in the very long-term. Remember, no one, including medical experts, has a good forecasting model for the timing and extent of COVID-19 impacts. But valuations on risk assets have significantly improved, the collective market psychology has moved to an extreme of panic and the monetary and fiscal policy backstops are slowly falling into place.

At times like these, taking a long-term view and staying invested is one of the most important decisions our clients can make to achieve their financial goals.

1Source: Refinitiv Datastream. As of March 13, 2020

2 The discount window refers to a monetary policy tool under which banks can borrow money from the Fed to ease temporary liquidity issues, capital buffer refers to mandatory capital that financial institutions must hold to help protect their balance sheets and intraday credit is a one-day financing mechanism the Fed makes available to banks 

 
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