02-Mar-2020

1) Market Volatility To Continue Despite The Fed
2) EUR/USD Climbed To A Three-Week High
3) RBA Rate Cut Expectations Shoot Through The Roof Following Chinese Data

1) Market Volatility To Continue Despite The Fed

This week, financial markets capitulated with volatility skyrocketing and cross-asset correlation rising sharply. Price action was especially brutal in markets where positioning was most crowded and consensus views most prevalent. Equity markets in the US and Europe collapsed and euro HY and IG spreads widened substantially, with cash bonds catching up with CDSs. The market priced in the probability of an emergency Fed cut before its next meeting on 18 March and markets now expect the ECB to cut rates by 10bp in June. US dollar funding became more expensive on Friday and Bund asset swap widened. Price action in EUR govies, covered, SAs and swaps was in general more orderly, which may reflect lighter positioning (or limited secondary turnover), while the USD weakened broadly due to Fed repricing. In Norway, EUR/NOK reached a record high, while the HY market weakened sharply.

The trigger behind the market turmoil was news last weekend that the coronavirus was spreading fast outside China, particularly in Italy, Iran and Korea. In recent days, the number of infected people has risen significantly in France, Germany and Spain. As our China economist Allan von Mehren argues, the number of infected people in the abovementioned countries may turn significantly higher in the coming weeks as a virus typically spreads exponentially in the early phase. In China’s case, the contagion did not slow down until tough restrictions were imposed and people started to stay inside, which we are not seeing in Europe yet. If you would like to receive Allan’s daily update, please reach out to him. The economic and financial damage has changed from temporary supply-side, value-chain disruptions, which the market and we initially expected, to risk of significant demand-side disruption across service sectors such as tourism, restaurants & hotels, entertainment and transportation.

Every economic and financial stress scenario is different, but the outcome depends on fundamentals, confidence and the policy response. Fundamentals are weak in my view. The virus comes at a difficult time for the global economy, as the US was set to slow due to fading fiscal stimulus and the Eurozone recovery is very fragile. In my view, the global economy is set to slow sharply in coming months due to the hit to global value chains, selective service industries and investments. Data over the weekend showed that China’s official manufacturing and non-manufacturing PMIs in February dropped to the lowest level on record. Confidence is fragile as the market questions policymakers’ ability to contain the virus and support the economy. How fast the virus spreads and how deadly it is will be key. It may be that policymakers in Italy and in other European countries would have to toughen restrictions for example by reducing free movement of people, which appears to have helped in China. The statement from Fed Chairman Powell on Friday night that the Fed is ready to act guarantees in my view that it will cut rates at the latest on 18 March. I believe developments in the coronavirus crisis and market volatility will determine whether it will cut before the 18 March and by 50bp instead of the usual 25bp. The Fed’s commitment may ease market tensions near term, but I do not think this will be the game changer. Instead, signs that policymakers are able to contain the virus and/or a series of demand supportive measures from major countries may stabilise sentiment.

We expect the global economy to stabilise and recover later in the year as production normalises and spending habits return to normal as the spread of the virus slows down. I would put this probability at 45%. There is a chance that the global economy recovers sharply due to low inventories, monetary expansion and fiscal stimulus (20% probability). However, uncertainty is currently extraordinarily high as it is very difficult to predict how the coronavirus will spread and how it will influence global value chains and human behaviour. What if the exponential growth of infected people seen in recent days in Italy, France, Germany and Spain continues and the crisis spreads to the US? Besides the human tragedy, there is a risk that the crisis drags on, triggering a global recession (35%). Corporate leverage in the US is elevated, while some asset prices look stretched such as US and German equities and housing markets in the US and Northern Europe. A sharp slowdown may expose such excesses with feedback loops into the real economy. In such a situation, I would expect the Fed to cut rates to 0% and the US, Germany and China to substantially ease fiscal policy. In the case of a significant global pandemic, which creates stresses in the financial system, there may be a coordinated central bank intervention and fiscal efforts like in the global financial crisis. In the coming week, the research team will publish a series of notes on the impact of the coronavirus on global macro, Scandi macro and the credit quality of Nordic industries and companies.

2) EUR/USD Climbed To A Three-Week High

EUR/USD climbed to a three-week high of 1.1053 last Friday and managed to close the week above 1.10, recovering around 250 pips from a nearly three-year low of 1.0777 scored on February 20. On Friday, Fed Chairman Jerome Powell issued a rare unscheduled statement. He said that even though fundamentals of the US economy remain strong, the bank is monitoring the coronavirus outbreak and stands ready to act to support growth. These comments were read as a hint at a possible rate cut at its next meeting on March 18, adding further pressure on the already weakened greenback and helping stocks to recover from session lows in Wall Street. The market is now pricing in a 25 bp rate cut from the Fed in March, while the odds of a 50 bp cut jumped following Powell’s statement.  On Friday night, the US also confirmed the first death from coronavirus in the country, fueling risk aversion.

Meanwhile, Chinese data over the weekend showed that manufacturing PMI dropped from 50 to 35.7 in February, even worse than the 46 expected. The composite PMI fell to a record low of 28.9 from 53 the previous month, while the non-manufacturing survey also hit a record low of 29.6 from 54.1. Data confirms that the coronavirus outbreak is taking its toll on the world’s second-largest economy.

From a technical perspective, EUR/USD maintains the bullish tone, according to short-term charts, although the RSI is approaching overbought levels again, favoring a stage of consolidations or even a correction before another leg higher. The pair has found resistance at the 1.1055 area, where the 100-day SMA stands. A break there would pave the way to the upside, with 1.1170 in sight. On the other hand, the 1.0950 zone should contain pullbacks to keep focus on the upside.

3) RBA Rate Cut Expectations Shoot Through The Roof Following Chinese Data

The Reserve Bank of Australia is due to meet on Tuesday to decide on its interest rate. The coronavirus and bush fires have been a likely catalyst for the market’s higher pricing of a rate cut as soon as tomorrow from the Reserve Bank of Australia. Indeed, OIS is at 127% for a 25 basis point cut, pricing in some chance of a 50bp cut. The RBA cash rate is currently at 0.75%. Markets are in a panic, and rightly so, leading to global equities suffering their sharpest declines since the 2008 financial crisis last week, while commodities also plunged, weighing on the value of the correlated AUD to fresh monthly lows. At the time fo writing, we have seen the number of cases of the coronavirus jump by 1,739 new cases of the infection confirmed over the past 24 hours. The total globally is 87,137.

Meanwhile, the RBA cut three times last year to spur firms to invest and hire in order to speed up economic growth and inflation. What makes this meeting so interesting is that the RBA’s governor, Lowe, is very reluctant to cut and is stuck between a hard place and a rock. The RBA needs to see if unemployment rises ( in Jan, rose from 5.1% back to 5.3% –19th March will show the Feb issue) and if there is no progress toward their inflation target – only then will Lowe pull the trigger, but that was before the recent escalation of coronavirus risks to the global economy.

However, we are now starting to see negative effects in the global economy after a key manufacturing gauge in Australia’s top trading partner China slump last month. Heavy losses are seen in US equity futures which declined by around 3%, while oil futures also weaker around 2.6% following the dismal Chinese PMI data over the weekend which printed the worst on record. China’s official manufacturing purchasing managers’ index (PMI) dropped to 35.7 in February from 50.0 in January, below the 38.8 figure reported in November 2008. The non-manufacturing PMI – a gauge of sentiment in the services and construction sectors – also dropped to 29.6 from 54.1 in January, the lowest since November 2011. This is a factor that has been the nail in the coffin as far as markets are concerned. Investors are looking to the Federal Reserve and other major central banks – despite their limited ammunition – to contain the fallout from the outbreak. Fed Chairman Jerome Powell in a statement on Friday said the US central bank is ready to cut rates as the epidemic “poses evolving risks” to the American economy. Such rhetoric is leading the market to believe rate cuts from all the central banks is imminent, including from an otherwise cautiously optimistic RBA that was expecting progress to be made towards the inflation target and full employment.

The weekend’s data from China is an alarming reality for the RBA to consider, but, always the optimist, Lowe will also find comfort in knowing that the National Development and Reform Commission spokesman Cong Liang said that over 90 per cent of industrial enterprises in Zhejiang province, one of the country’s top manufacturing bases, has, in fact, resumed operation. According to Cong, over 70 per cent of production in the manufacturing and export hubs of Guangdong, Jiangsu, Shandong and Liaoning had also restarted. With hopes that the virus will be contained and that the worst is behind China, in terms of the rate of infections. In this case, the most optimistic of observers might regard any immediate measures taken by authorities are that of a precautionary measure only, due to the higher chance of global recession. Casting minds back, RBA officials’ commentary in recent months had highlighted that global developments could be an important driver of policy outcomes.

On the other hand, the latest rhetoric from the board was not so dovish which leads some to believe that Tuesday’s RBA Board Meeting should see the Bank keep the cash rate on hold at 0.75%. “So far the Bank’s message has been that the hurdle to cutting is high, pointing to the long and variable lags of policy. While we don’t expect the Bank to express coronavirus concerns yet, the Bank’s take on the rise in the unemployment rate will be worth noting,” analysts at TD Securities argued.

This seems to fit in with the narrative across most central banks. Late on Friday Fed Chair Powell made the comment that the Fed would “act as appropriate” to support the economy. Markets took that as a tip of the hat for a rate cut, perhaps even as soon as this month on the 17-18 March. We have also hard from Europe, with central bankers noting downward risks to growth forecasts due to the virus. However, Europan Central Bank President Lagarde and Bundesbank President Weidmann both indicated that the situation does not warrant an immediate cut. So, perhaps markets are getting too ahead of themselves. But then again, that was all before the weekend’s data where a key manufacturing gauge in China slumped last month, although this should come at no surprise to the RBA board.

Should the RBA hold and surprise many, it could be due to the fact that a coordinated effort from a collective of central banks is being but together behind closed doors at the moment. In the weekend press, reading an article by Reuters, a top economist for the US bank lobby – a former Fed insider – was cited to issue a remarkably specific prediction in a blog titled “Don’t keep your powder dry”. Written by Bill Nelson, chief economist at the Bank Policy Institute who worked on the Fed’s responses to the 2007-2008 financial crisis, it is predicted that a “coordinated global interest rate cut by the top central banks, such as the one executed at the height of the crisis in October 2008 by the Fed and five other central banks. They will possibly include in this action the People’s Bank of China and the Hong Kong Monetary Authority, the two banks whose economies have so far suffered most from the outbreak.