Feature Stories | Mar 20 2020
Nothing short of containment and massive coordinated monetary and fiscal stimulus will save the global economy, economists believe. The RBA is now in on the act and the Australian government is doing its bit as well.
-Monetary and fiscal stimulus rolled out across the globe
-RBA goes unconventional
-Forget the GFC, this is BIG
-Will it work?
By Greg Peel
"Credit meltdowns are fuelled by self-perpetuating panics. The uncertainty of economic impact of COVID-19, collapse in the oil price and rising geopolitical pressures are aggravated by computerized trading and more than a decade of extreme monetary policies, which left investors marooned in overcrowded positions. Unless this death spiral' is arrested, all assets (except extreme safety) will collapse, capital will freeze, and liquidity disappear. At that point our entire asset-based financialized world will reset. Funds will collapse, pensions won't get paid and we will need to recognize that decades of growth were not sustainable, ultimately converging money supply and GDP, and in the process wiping out years of rising standards of living. While it sounds extreme, if there is no coordinated action, this will be the likely outcome."
–Macquarie Wealth Management, March 13
Macquarie believes that rate cuts by themselves are not sufficient, hence central banks need to embark on quantitative easing with no limitations on size or asset classes. Regulatory and prudential controls must also be aggressively deployed, such as reducing capital buffers. But the government will also need to do its bit with fiscal policies, including aggressive spending and bail-outs of the more vulnerable segments.
"One can't predict when policymakers will coalesce but a global economic reset is neither politically nor socially acceptable. Indeed, yesterday's liquidation might be eventually heralded as one of the events that ushered the new world."
A Call to Arms
The "yesterday" to which Macquarie refers was the -10% plunge in the ASX200 and in the S&P500, the biggest one-day falls since the 1987 crash.
The US Federal Reserve has since slashed its cash rate by -100 basis points to the 0.00-0.25% lower bound, having already cut by -50 points only a week earlier. The last time the Fed cut by -100 points, also to zero, was October 2008 after the collapse of Lehman Bros.
That was the last in a trail of ten cash rate cuts, which began in September 2007 at the starting point of 5.25%. The Fed delivered what was then described as a "shock & awe" cut of -50 points, which it was assumed at the time would signal the end of this pesky Credit Crunch. Between the first cut and the last, the Fed made a further three cuts of -25 points, three of -50bp and two of -75bp.
The Fed cash rate remained at the zero bound until 2015, when the Fed began a series of nine rate increases of 25 points each, culminating in December 2018, which cemented the last major stock market correction. The starting point for the Fed's two virus-related cuts was 1.75%, a far cry from 5.25%. While the GFC was a slow motion event compared with coronavirus, it is clear the Fed learned a lesson at that time. Don't muck around. Go early, go hard.
Go QE.
The concept of quantitative easing was merely a theory before the Fed enacted it in 2008, retrospectively dubbed QE1, and in so doing prompted the US stock market bottom in March 2009 following a -50% fall from October 2007. At the time of writing, the S&P500 has fallen -29% in less than a month.
On top of its -100 point rate cut last weekend, the Fed announced a US$700bn QE program split US$500bn in US government bond purchases and US$200bn in mortgage-backed security purchases. It has also began making what are ostensibly limitless injections into overnight money markets and commercial paper markets and then on to municipal bond markets to ensure liquidity.
US fiscal stimulus packages are moving slowly through Congress, although urgency has finally crept in, and US$1.3trn has been pledged to date across various targeted measures. Given the extent of the government's prior current account deficit, further trillions in fiscal injections suggest "limitless" as well. The printing press is running hot, yet the US dollar is now back on the rise given rate cuts, QE and fiscal stimulus have become a worldwide response.
Subsequent to the Bank of England cutting its cash rate by -50 points, the UK government has announced a GBP350bn stimulus package of loans, grants and tax relief. That's around 1.7 times larger per capita than the US package.
Having been initially criticised for promising much and doing nothing, the European Central Bank, which already has a zero cash rate, has announced a EUR750bn purchasing program of public and private sector securities.
Everyone's in on it
To date, the Australian government has announced a $2.4bn health package and a $17.6bn economic package and is set to announce a second economic package, likely larger still. Having already cut by -25 points, the Reserve Bank of Australia has now cut by another -25% points to 0.25%. The reason the RBA did not follow the trend and cut to zero is because even before the virus outbreak the central bank said it saw anything below 0.25% as ineffective, hence that was the point at which unconventional measures could be enacted.
The RBA had also suggested it was sceptical about QE, hence there was strong speculation it would not go down the QE path initially but rather first enact "yield curve control" (YCC), which in simple terms means setting a target rate not just for overnight cash but for a maturity or maturities further down the yield curve, such as four to five years, which is where the concentration of Australian debt securities lies.
Typically when the RBA makes cash rate adjustments money markets adjust on their own, not requiring a draw on the central bank balance sheet. It was assumed the RBA was hoping the same might be true if it were to set a target rate for five year bonds.
As it transpires, the RBA has gone YCC. As well as setting a 0.25% target rate for overnight cash, it has set a 0.25% target for three year bonds, a little shorter than anticipated. To maintain the target, the RBA will purchase government (federal) and semi-government (state/Territory) bonds across maturities in the secondary market.
A point to note here: there is no such thing as a three-year bond except on the day one is issued. As each day passes, that bond becomes shorter than a three-year bond. The price quoted as the three-year bond rate, ten-year and other maturities is a running calculation based on prevailing market prices at the time. Hence, while the RBA may purchase bonds "across the curve", it is zeroing in on the three-year period.
The RBA has not put a figure on its intended bond purchase total, as have the Fed (US$700bn) and the ECB (E750bn) for example, because it will only buy in the secondary market (existing bonds) rather than primary (new issue) market. This implies the central bank will only buy when necessary, may not even need to buy at all if the market adjusts by itself, and may need to even sell again if the three-year rate falls too low.
However, given market dislocation driven by virus impact uncertainty, and a market physically disrupted simply because traders are forced to work alone from home, the RBA will likely need to jump straight in to close widening bid/asks spreads and ensure ample liquidity from the outset.
The RBA has also been making frequent injections into the short term credit markets to ensure liquidity and will continue to do so.
And the RBA will provide a three-year term funding facility for Australian banks at 0.25% for up to 3% of that bank's existing credit, or more if the money is lent to businesses, especially SMEs. That facility does have a number "at least" $90bn.
The jury is out to some extent as to whether the RBA's plan amounts to "QE" or not. The governor says no. Economists say yes, because bond purchases announced to underpin yield curve control are by any other name QE. It's just a label anyway, and has expanded since the GFC to generally refer to any "unconventional" central bank policy.
Will it Work?
Generally, JPMorgan' economists regard the RBA's announcement as significant. After a slow start, the central bank has delivered a package that should engineer a meaningful easing of financial conditions, assuming long-end bond yields can be encouraged lower, the economists suggest. This should help to preserve the flow of cheap credit into the economy for both households and SMEs, and indeed the term funding facility is structured such that incentives are stronger for banks to lend to SMEs.
The RBA's actions are decisive and broader in scope than the market was expecting, Citi's economists suggest. In addition to providing the expected -25bps cash rate reduction, the central bank effectively provided forward guidance that the cash rate will remain unchanged for at least a few years, possibly longer. This statement should help anchor short-dated yields at a generational low.
Citi had previously argued that a term funding facility for the banking sector was a necessary requirement.
The RBA also offered to ensure full monetary policy transmission approaching the effective lower bound, despite not even being considered by the governor in his speech last December. The change of heart is welcome, says Citi, and will support banks providing credit at low rates for a meaningful period of time.
"In summary, the RBA's actions will ensure that the financial system can support the real economy, not just now but when demand growth improves, which will help the recovery process more generally when it occurs."
With regard the term funding facility for banks, UBS notes this will support the supply of credit to SMEs, but it remains to be seen if demand will meet it. Given the rapidly deteriorating economic outlook, the economists are not convinced SMEs will rush to borrow, even at concessional rates. They think more needs to be done, and still expect a recession and spike in unemployment towards their pandemic scenario of 8%.
The Australian Government flagged more fiscal stimulus in coming days, which will be substantially different to the first package, UBS notes, likely including income support which the economists expect to be much larger at $50bn plus, or 2.5% of GDP, and could easily total $100bn (5%), versus the $25bn or so announced so far (including state governments).
Bigger then the GFC
Do we now have globally coordinated action?
Since mid-January, 18 of the 30 central banks Morgan Stanley economists cover have eased monetary policy. The global weighted average policy rate has declined -54 basis points since December 2019 and -166bp since December 2018. By the end of the June quarter 2020, Morgan Stanley expects 25 central banks to be easing. Once the Bank of England relaunches its QE program, we will have all G4 (US, UK, Japan, eurozone) central banks back on the quantitative easing path.
While the initial response from developed economies was slow, the economists note, over the last few days, as economic and financial market disruptions persist, we have started to see strong commitments from policy makers, indicating that a sizeable fiscal expansion plan is in the offing.
Morgan Stanley now expects that in the G4 plus China, the combined primary fiscal balance will rise to around US$1.7trn. As a percentage of GDP, the G4 plus China cyclically adjusted primary deficit will rise. Indeed, the G4 plus China deficit will reach 6.9% in 2020, higher than the GFC's 6.5% in 2009.
Global monetary and fiscal responses to the GFC were slow, mostly because no one (bar a few smart people) saw it coming, no one outside the market understood it, few inside the market actually understood it, and it played out in slow motion over a period of time. In June 2007, two Merrill Lynch funds holding sub-prime collateralised debt obligations could not find buyers. One year and three months later, Lehman Brothers went under.
As noted, back then quantitative easing was just a theory. It was not put into action by the Fed until November 2008 and given markets kept falling, was bumped up in size in March 2009. Finally Wall Street turned. March 2009 was also the month the then Australian government provided a cash handout of $900 to most Australians, the most significant of its fiscal responses.
Coronavirus, on the other hand, came out of the blue. The subsequent plunge into a bear market is the fastest ever seen. The GFC taught central banks and governments a valuable lesson not only what tools can be used, but how quickly they should be used.
Enter Modern Money Theory, which in essence suggests any country which prints its own currency can happily print as much as it likes without fear of repercussion. If the GFC alerted the world to a thing called QE, the virus will soon educate the world on the concept of MMT.
How long will it take to pay back all this suddenly accumulated and massive debt? MMT suggests it doesn't matter.
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