Close The Borders And Unite The World

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.


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