These are challenging times is the understatement of the decade.
The fear of pandemic has arrived and is causing great distress for families and the nation at large as we are tending to the sick and those forced into a change of everyday patterns. Since the beginning of February, we at NOTES FROM UNDERGROUND have been discussing the onset of the DEMAND SHOCK which would cause problems in the financial system because of the massive build-up of debt on a global scale. If businesses cannot operate as people hunker down in an effort to slow the spread of the virus then it goes without saying that DEMAND would suffer. If demand suffers on a global basis borrowers without cash reserves will struggle to sustain their businesses.
My mind turns to 9/11 when all Americans were admonished to get out, go to entertainment and food venues so as not to let the terrorists win and change our beloved lifestyles: spend, spend, spend. Then-President George W. Bush went to Yankee Stadium to toss out the first pitch of the World Series.
Yet this time it is different as we are self-isolating in an effort to win against the virus. All major sports have shut down in an effort to eliminate the COVID-19 spread. Now restaurants, movie theaters, schools and offices are being closed.
The economic machine is being forced to slow to a crawl but the overhang of debt remains. This is the issue of the DEMAND SHOCK we have spent so much time discussing on this blog. If this situation continues for a few months how fast do you think unemployment rises to 5.5% or even higher? The effort to limit the pain by fiscal solutions will prove a very valuable tool but for how long can the government go without any revenue stream before FOREIGN LENDERS turn off the spigot?
The initial response from the administration will be a form of Modern Monetary Theory for Jay Powell is a believer in the printing press as has suggested in the past. It is the fear of the demand shock that has the markets so roiled and causing gigantic losses for those involved in the RISK PARITY and SHORT VOL strategies. These efforts have crushed the fundamental-based traders for the last eight years as the FED‘s efforts to keep the liquidity flowing resulted in COMPLACENCY.
Passive investing ruled the day but the onset of the FEAR of a DEMAND SHOCK has disrupted the underlying premise of the mathematical models driving investment strategies. Even the proverbial safe havens have been “taken to the wood shed” as the long-held positions of the derivative kingpins have been liquidated in an effort to raise cash. The FED must have received word of a cash shortage as they quickly offered trillions of repo opeations for fears of a calamity in the repo markets. And yet, FRA/OIS spread is reflecting stress in the credit market, as it widened to more than 80 basis points.
The front March EURODOLLAR contract closed down 17 tics in response to the FRA/OIS widening. The 2/10 yield curve widened dramatically, closing above 45 basis points. If the curve continues to steepen (as I suspect it will), it could be a positive for the global macro world as banks will be able to generate profits, even in a zero interest rate world.
It will also result in a weaker DOLLAR, which is beneficial to the emerging market as they are loaded with DOLLAR-DENOMINATED DEBT. As the DOLLAR rallies against the emerging market currencies the debt load becomes more onerous.
This development is now acting as a drag on the world as COMMODITY INDEXES are at 30-year lows. Many commodity producers cannot generate enough revenue to pay back debt causing a demand shock within the economies that fuel their existence. In my opinion, the FED OUGHT TO announce an expansion of the DOLLAR SWAP LINES WITH EMERGING MARKET CENTRAL BANKS to ensure they’re able to meeting their financing needs.
The FED already has this agreement in place with the developed world banks. This is the role of the global reserve currency as the lender of last resort. The DOLLAR’S ROLE is most often an exorbitant privilege but in times of a GLOBAL DEMAND SHOCK it becomes an exorbitant burden.
***ECB President Christine Lagarde is being castigated for not cutting rates on Thursday and only increasing QE by roughly 120 billion for the remainder of the year in an effort to provide stability to the corporate bond market and small/medium business loans. I think this was the correct policy for it turns the focus onto the finance ministers of Europe to utilize fiscal policy as an economic stimulant.
Immediately following the meeting, German Chancellor Angela Merkel moved to suspend the fiscal strait jacket of SCHWARZ NULL: the black zero. The Germans will set the agenda for the fiscal bonds known as the Maastricht Accord. Lagarde was also admonished for a “faux pas” as she stated that the ECB’s role was not to compress yield differentials in an effort to replicate Mario Draghi’s “whatever it takes” to save the EURO.
The German/Italian, German/French 10-year yield differentials widened materially in response. Was this a “faux pas”? I think NEIN as it was a signal from Lagarde to all the EU ministers that if they wanted to prevent another financial crisis it is time to generate the infrastructure for a EUROBOND. She is using this crisis to effect her mandate: a EUROBOND supported by FISCAL HARMONIZATION. The Lagarde press conference and actions were a classic example of LESS IS MORE in EUROLAND.
***Also note: In an unscheduled announcement, the Reserve Bank of New Zealand slashed its key interest rate to 0.25% from 1% and said it will remain at that level for at least 12 months. And, if more stimulus is required, the RBNZ would prefer QE over rate cuts. The central bank cited the virus’s impact on the economy, referring to it as “significant,” while qualifying that the financial system remains sound.
***Amid the chaos there was a Bloomberg story about Treasury Secretary Mnuchin meeting with the Russian Ambassador to the U.S. Did they discuss Russian oil cuts in a response to the removal of sanctions, perhaps? This would alleviate some of the problems pushing the demand shock.
Cathy I’m lost I said though I knew she was sleeping,And I’m empty and aching and I don’t know whyCounting the cars on the New Jersey turnpikeThey’ve all come to look for America.