Nordea AM: The Fed's Placebo Effect
Nordea AM: The Fed's Placebo Effect
Can interest rate cuts save us from Covid-19? Sébastien Galy, Sr. Macro Strategist at Nordea Asset Management, comments:
“In the coming weeks, the Fed will meet (March 18) and the ECB will meet (March 12) to discuss, among other things, a response to Covid-19. Currently the market expects 1.7 rate cuts at the next Fed meeting and a total of 3.4 cuts by the end of the year. The market expects 0.8 rate cuts at the next ECB meeting and a total of two rate cuts by the end of the year. While another 50bp rate cut is likely from the Fed at its next meeting as it front runs the movement, the ECB is less likely to make such a move given the risk of a backlash from the United States on a theme of currency devaluation. The odds of this are roughly 30%. Both will consider ways to alleviate pressure and improve the effectiveness of monetary policy, so some innovation should be expected.
The question is what monetary policy can achieve when faced with Covid-19. If liquidity can be directed and subsidized, as in China, then it is very effective—what could be a liquidity and credit crisis for many companies simply impairs the balance sheets of banks for a while.
Unfortunately, the West is not so lucky as banks must protect themselves and must be incentivized to lend. However, from East to West, monetary policy has a placebo effect: most households and, to some extent, the market believe that monetary policy can cure most ills – even a supply shock.
The SARS crisis lasted nine months and Covid-19 most likely will follow a similar pattern: pockets of contagion will damage some economies severely from Japan to South Korea, China, France, Italy and Germany. The OECD projects a severe slowdown of the global economy. The IMF, likely under political pressure, anticipates a slight slowdown (it is a well-known fact that tables and graphs issued by the IMF are far more informative than their texts).
Faced with this, the market has been on a very bumpy ride with positions being squeezed every day. What we see ahead of us is another week of elevated volatility before traded or implied volatility, e.g. the VIX drops considerably. We would suggest that so-called “flexible solutions” are increasingly interesting as investors rebalance their portfolios to exploit risk premia. Beyond this, the environment should start to become more supportive of equities, though it will still be a somewhat bumpy ride for many weeks to come as economic data filters in along with profit warnings.”