Tuesday morning, the Federal Reserve surprised markets with an emergency interest rate cut of 50 basis points (bps). The Fed’s move is likely the first in a series of synchronized actions by the G-7 aiming to support developed market economies as the coronavirus continues to spread outside of China. The Fed’s move comes one day after a G-7 meeting in which finance ministers and central bank governors discussed the global economic effects of the COVID-19 outbreak. Even if we see a coordinated global approach from both developed and emerging markets, if the economy remains vulnerable, the Fed may still take additional action in the near future.
The Fed’s shock-and-awe approach was clearly intended to arrest the equity market correction and to stabilize broader financial conditions. Rate cuts cannot stop the spread of the virus, nor are they particularly well-suited to deal with supply chain disruptions; however, they can contribute to an environment where easy financial conditions buffer the economic shock, as opposed to exacerbate it.
First and foremost, the Fed wants to avoid a crisis of confidence that disrupts public credit markets and leads to an abrupt pullback in bank lending. Without Fed actions to ameliorate market panic, credit could tighten at the same time that weaker businesses run into cash flow problems related to the global disruptions in manufacturing and trade or domestic disruptions in travel and services consumption. Travel and tourism make up roughly 3% of the U.S. economy, while the largest metropolitan statistical areas (MSAs) collectively account for over 30% of U.S. GDP (source: Bureau of Economic Analysis). A U.S. virus outbreak that sharply disrupts activity in these areas could severely depress growth. And as we highlighted in our recent Cyclical Outlook, large areas of the corporate private credit market are especially vulnerable to a general deterioration in economic growth. Private credit, leveraged lending, and high yield markets hold large concentrations of debt in sectors that are highly cyclical. In addition, energy, transportation, gaming, hospitality, and airline sectors all appear vulnerable to a larger U.S. domestic outbreak of the disease, which would limit travel and tourism.
History teaches that epidemics tend to have temporary effects on economies and markets. Nonetheless, seemingly temporary revenue shocks, if prolonged, can lead to bankruptcies, rising unemployment, and other adverse effects on the economy before the ultimate rebound. Small to midsize companies, which account for about 70% of U.S. employment (according to ADP), are particularly sensitive to tighter credit conditions and slower growth.
With that in mind, the equity and credit markets’ reaction to the Fed’s announcement is troubling. After an initial positive knee-jerk reaction, the U.S. equity market rapidly turned negative, and credit spreads widened. In his press conference following the rate cut, Fed Chair Jerome Powell noted that the Fed is happy with the current stance of monetary policy. However, a continued fall in equity markets suggests that the Fed may need to do more, as early as their March 18 meeting, to stabilize financial conditions. Eventually, additional actions to support banks and ensure ample liquidity across the banking sector may be needed. The Fed’s discount window will backstop short-term funding, but the Fed may need to do more where it can if bank funding market stresses flare up.
Synchronized actions around the world
A coordinated global policy response and targeted fiscal actions are also likely – and needed. As Powell stated, “The virus outbreak is something that will require a multi-faceted response.” As such, we expect global fiscal authorities and central banks to act soon.
The European Central Bank (ECB) will likely increase the pace of its asset purchases and make its long-term refinancing operations (LTROs, which are aimed at improving bank lending) more generous. And while it is possible that the central bank cuts policy rates further, it is far from clear that the benefits of doing so outweigh the costs (see our recent paper, “Negative Rates: Negative View”).
The Bank of Canada is likely to cut its policy rate by 50 bps at its regularly scheduled meeting tomorrow, while the Bank of England could also cut by 25 bps – 50bps in response to market pressures.
On the fiscal side, governments across Europe will likely add some fiscal easing, although political constraints in the euro area make us wary of expecting much of a response on this front.
In emerging markets (EM), several central banks are also likely to ease policy in an effort to counter the disinflationary shock, especially given the likely significant spillover of the dramatic drop in Chinese growth. EM real rates (which exclude the effects of inflation) are positive and high relative to those of developed markets, giving central banks relatively more room for interest rate cuts. Also, EM economies are still mostly functioning below their long-term potential, in our view, and we expect this to continue – or even worsen – given the magnitude of the Chinese slowdown; moreover, and importantly, EM inflation dynamics remain contained.
Most emerging markets are also in a better position than in years past to use monetary policy at their discretion: EM inflation responses to EM currency moves have generally declined and become more stable, giving central banks more room to cut policy rates when faced with macroeconomic shocks. Also, fiscal policy across EM, outside of a few cases, is relatively more constrained and tends to operate with longer lags. We believe that these factors leave monetary policy as the most effective tool that EM economies have to help counter a global slowdown.
At a global level, synchronized policy stimulus would likely have mutually reinforcing effects and also help keep currency moves in check. On that basis, we expect action soon from fiscal and monetary policymakers around the world.
This blog was published on 3 March 2020.
Tiffany Wilding is a PIMCO economist focusing on the U.S., Nicola Mai is a portfolio manager and leads sovereign credit research in Europe, and Lupin Rahman is a portfolio manager and head of EM sovereign credit. All are regular contributors to the PIMCO Blog.