Just A Matter Of Time…

Authored by Michael Every via Rabobank,

A slightly more dovish Fed (see below), and the corresponding perceived increase in the odds of further stimulus by the US central bank, failed to excite investors much as the coronavirus continues to dampen the mood on global markets. Asian equities are down sharply again, with the Hang Seng index losing 2.9%, and both the Nikkei 225 and the KOSPI currently down 1.7% on the day. While it appeared like the initial virus scare had faded, this risk-off sentiment was reinvigorated by news that the virus may spread unnoticed, and news that the WHO may reconsider declaring a global emergency as “progress of the virus in some countries, and especially human-to-human transmission” are worrying them.

US Treasury yields fell on the back of the risk-off sentiment and reassessment of the FOMC’s likely next policy move. The 10y Treasury has dipped below 1.6%, dragging German Bund yields down alongside.

As we note in a report published just prior to this Daily, experience with virus outbreaks in the past shows that markets often bounce back quickly, but even if the virus outbreak turns out be comparable to SARS, its global economic effects are likely to be larger, as China has a much bigger share in the global economy nowadays. At this point, we don’t expect any permanent damage of the epidemic to the Chinese economy or other regions across the globe, but in case of a further spread of the virus globally or in case of defaults among China’s highly indebted non-financial corporates due to the containment measures, the risk of permanent damage increases significantly.

Barring such a scenario, the effects of the risk-off sentiment are probably temporary.

Yet, to the extent that the fall in yields wasn’t driven by the coronavirus, but by a re-evaluation of the FOMC’s future policy stance, this decline may be a bit more permanent.

The FOMC kept the target range for the federal funds rate unchanged at 1.50%-1.75%, but the Board of Governors, as expected, did make an upward technical adjustment of 5bp to the IOER and the ON RRP rate to force the effective federal funds rate closer to the midpoint of the current target range.

Powell repeated that it would take a ‘material reassessment’ of the economic outlook to change the current stance of monetary policy. But, overall, the FOMC statement and Powell sounded dovish with a slight downgrade in their assessment of household spending; a more explicit commitment to get inflation back to target; an acknowledgement of the serious nature of the coronavirus; and the acknowledgement of remaining trade policy uncertainty. Finally, Powell said that the phase one trade deal and the USMCA were potentially positive developments, but he stressed also that trade policy uncertainty remains elevated with businesses having a wait and see attitude whether this is going to be sustained.

As our US strategist, Philip Marey, concluded: on balance, it sounded as if any ‘material reassessment’ of the outlook is more likely to lead to a rate cut than a hike. Of course, he has long warned that the US economy is actually already late in the cycle, rather than the Fed’s assessment that their ‘mid-cycle adjustment’ will be sufficient to keep the economy humming along nicely. And, Philip argues, it is just a matter of time before the FOMC realises this as well. Therefore, we expect the Fed will be forced to cut rates all the way back to zero before the end of the year.

Furthermore, the FOMC decided to keep supporting the repo market, directing the Open Market Desk to continue its purchases of Treasury bills at least into Q2, and to continue its term and overnight repo operations at least through April (instead of January). Given the recent expansion of the balance sheet, Philip estimated that a 5 to 10bp technical hike to the IOER should be sufficient to push the effective federal funds rate back up towards the midpoint of the target range. The Fed opted for the lower of these two options yesterday. So, with the Fed continuing to expand its balance sheet, we may see the Board make another 5bp hike in the IOER and ON RRP rates (at least relative to the target for the federal funds rate) somewhere down the road.