Via Financial Times

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Where the US Treasury bond market leads, the US Federal Reserve follows. The Fed has repeated the kind of emergency easing action seen at times during 2008, and 2001. Hardly a comforting point of comparison in the near term, given how tumultuous those years were. A 10-year Treasury yield falling below 1 per cent on Tuesday afternoon in New York for the first time is pretty telling, with Wall Street hitting fresh lows for the day, led by tech and financials.

After an anodyne statement in the wake of Tuesday’s conference call between finance ministers and central bankers, the Fed stepped up and delivered a 50 basis point rate cut just after Wall Street opened. That pre-emptive action from the US central bank followed easing from the likes of Australia and Malaysia earlier on Tuesday. 

Central banks with room to ease are moving to head off greater financial market turmoil (expect an easing from the Bank of Canada on Wednesday) and the rationale from the Fed and repeated during Jay Powell’s press conference on Tuesday is that “the coronavirus poses evolving risks to economic activity”. 

In other words, the risk of a recession is rising given the potential double-whammy of a supply and demand shock hitting economic activity. This meets the definition of a “material change” for the central bank and why the fed funds rate now sits in a range of 1 to 1.25 per cent, with scope for falling lower.

Officials are clearly anxious to get ahead of financial markets, pricing in the worst-case scenario from the coronavirus hitting the US and global economy. For all the focus on an equity rebound on Monday, Treasury yields and credit did not reverse course. The memory of market turmoil from late 2018 via a sharp tightening in financial conditions is relatively fresh for the current Federal Open Market Committee.

Marc Ostwald at ADM Investor Services highlights the recent rise in financial conditions via the Goldman Sachs index versus the midpoint of the fed funds rate.

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The early 2016 rise in US financial conditions index prompted the Fed to pause rate hikes for a year, then came the lesson of late 2018.

Marc concludes: 

“The renewed sharp tightening in financial conditions over the past fortnight has clearly prompted it [the Fed] to hit the panic button.”

The broader market reaction on Tuesday is logical in terms of a weaker dollar and higher gold price, with interest rates narrowing between the US and other leading economies. A weaker US dollar is good news for a global financial system loaded up with debt denominated in the reserve currency. Emerging market credit needs help and this is why Fed policy matters beyond the US economy. A weaker dollar also boosts foreign revenues for S&P 500 companies with global operations, and that’s also required at the moment, given fragile equity sentiment.

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Treasury yields, led by the policy sensitive two-year note have fallen hard, suggesting further Fed rate cuts are coming. That 10-year yield below 1 per cent reflects the bond market seeing overnight rates falling towards zero and staying there for some time.

As for equities, fresh off a powerful bounce on Monday, the outlook is decidedly treacherous. This hardly comes as a huge surprise. Selling into bounces usually defines equity trading for some time in the wake of the sharp slide that we saw last week. Risk managers are running the show in many portfolios and this raises the prospect of investors with “trapped” or “underwater” positions, either selling into equity and credit rallies. The early rise for Wall Street on Tuesday (the S&P 500 was up 1.5 per cent after the rate cut) was brief. This kind of dynamic keeps market volatility elevated for a while yet. Tuesday’s range for the S&P 500 was over 5 percentage points between the high and low. 

But credit is driving the bus, as any evidence of strains for highly indebted companies will spur a bigger washout in equities, tightening financial conditions and blowing back across the broader economy. More leveraged loan deals are being delayed and unless this freeze in activity ebbs, Treasury yields will keep dropping, while equities stay under pressure.

The bigger question for investors is to what extent economic disruption weighs on corporate profits. Jefferies believes working capital requirements versus debt refinancing from companies “will ultimately determine whether global equities escape from Covid-19 with a mild slowdown in earnings growth or a recession”.

Since the start of the year, growth expectations in earnings per share estimates for the S&P 500 (a global barometer given its ranks of multinationals) has slid from about 10 per cent towards 7 per cent. Some such as Goldman Sachs made waves last week, with a call of flat earnings growth in 2020. Jefferies believes there is “a possible bear case that this year’s earnings growth could easily undershoot by 2/3”. 

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Here’s the trimming that Fidelity International has recently applied to earnings estimates, although with a caveat that at this juncture, companies lack insight into the ultimate damage to their bottom lines. 

That’s the rationale for Tuesday’s pre-emptive Fed easing and also why the bond market expects further rate cuts are coming. 

True, many question to what degree lower overnight rates can offset an economic shock spurred by supply chain disruptions and quarantines that restrict activity and spending. (At least US homeowners with fixed rate mortgages can refinance at lower rates.) But this is just the start for the Fed and other central banks if the fear of a broader and deeper economic shock ensues. 

Lena Komileva at G+ Economics believes:

“The bulk of the economic adjustment, in the form of cancelled business investment, capital market activity and consumer spending in response to the virus spread and its effects on global trade, travel and liquidity transfers, still lies ahead, immune to the normal cyclical hedges of rate cuts.”

Lena adds: 

“In the most likely scenario, the peak in global infections will lag the peak of infections in China, and the peak of the economic shock will lag the peak of infections globally.”

Prepare for the greater expansion of central bank balance sheets and for governments implementing fiscal measures. This combination and one delivered in rapid fire fashion shapes up as the best approach given the potential economic and business waves from the coronavirus. 

Anna Stupnytska, head of global macro at Fidelity International makes this point: 

“While easier monetary policy helps sentiment, central banks should not be acting in isolation — the governments should step in with fiscal measures that are timely and well designed, supporting the economies that struggle not just from the virus itself but also from preventative measures that — in some cases — have ground activity to a halt.”

Quick Hits — What’s on the markets radar

Super Tuesday beckons for political junkies and markets are also watching the outcome of the Democratic primary horse race. About 34 per cent of pledged delegates (1,357 out of a total of 3,979) are up for grabs as voters head for the polls across 14 states. 

Lori Calvasina, head of US equity strategy at RBC Capital Markets says a good Super Tuesday result for Senator Bernie Sanders “seems likely to unsettle stocks” and she adds that their quarterly survey of clients shows:

“Investor confidence has been eroding, and victory by Sanders has been consistently viewed as a negative outcome for the stock market.”

Sanders is seen prevailing in Texas and California, the two states with the largest amount of delegates up for grabs. 

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Step forward a Joe Biden with momentum (a factor that markets rather like to see) after his South Carolina primary win over the weekend. Moderate Democrats are also rallying behind Biden in an effort to head off Sanders, an outcome that would help ease market anxiety, but likely entails a brokered convention in July. Another horse just leaving the starting gate is Mike Bloomberg, the billionaire former mayor of New York, who will appear on ballots for the first time, having skipped earlier contests. Here the risk for Biden is that he loses ground in the event of a good showing for Bloomberg.

Lori notes that a better result for Biden “may help US equity markets stabilise further, at least in the short term” and she sums up the broader race as follows:

“While most equity investors have viewed Trump as the most favourable outcome for stocks and Sanders as one of the most negative outcomes, Biden has been somewhere in the middle.”

As for the odds, Sanders holds a narrow lead over Biden.

Brown Brothers Harriman observe:

“The prospect of a moderate candidate running against Trump is an obvious positive for markets, even if it’s being drowned out for now by the virus concerns.”

Rather than wait for further policy medicine, markets are ultimately waiting for an clear sign that the virus is ebbing. Or as Unigestion write:

“If macro conditions do not deteriorate too much, we could very well end up in a situation similar to that at the end of last summer: cheaper valuations in a much better macro situation than most investors would expect.”

One promising development on that front is a sign that China’s silicon valley is returning to normal when looking at the latest traffic congestion data from Guangdong, via TomTom. The red line is moving closer towards the blue line that represents average congestion for drivers last year. 

The importance of this message is mainly one for commodity prices and other proxies, such as the Australian dollar, all of which have been hit hard by China’s supply shock.

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