Dubai, United Arab Emirates,12 March 2020:
The spread of the new coronavirus or COVID‐19 has shaken financial markets and economies across the world. In the past week, equity markets have seen dramatic declines, the US Treasury bond yield has fallen to an all-time low, the Chinese economy has virtually came to a standstill, tourist and business travel has collapsed, and supply chains for the production of goods have been disrupted.
John Greenwood, Invesco’s Chief Economist, attributes the fact that markets are reacting so violently to the uncertainty and unpredictability of the virus. “In my view these reactions are understandable only in the short term, and in light of the fact that nobody can accurately forecast the course of this scourge,” he said. “Markets hate uncertainty.”
In the medium and long-term, the US economy is in very good shape and the business cycle expansion is set to continue. According to Greenwood, balance sheets are sound and there is ample monetary support for continued growth with low inflation.
The biggest problem lies with international supply chain disruptions, especially with Asia. Though there are some supply chains exclusively in America or Europe, many highvalue-added components and lowvalue-added goods are manufactured in Asia. Further, most of the trade finance that underpins this activity is US-dollar denominated supplied by the local banks, whose access to dollar funding is limited.
Any sign of stress will show up in these peripheral markets first, then through the “payment chain” will affect US banks as providers of dollar financing and ultimately to the Fed as the supplier of dollars as last resort.
According to Greenwood’s analysis, the funding problems may already have started to show in the US money markets, where the recent term repo auction conducted by the New York Fed was three times oversubscribed, indicating that dealers anticipate the need for cash to meet liquidity needs of their correspondent banks in Asia or to ensure they are ready for the upcoming US Treasury auctions.
In an effort to slow the economic plunge, the Fed cut its US base rate by 50 basis points last week. Greenwood believes this cut was not enough and has been driven by misguided theories about what interest rates can achieve. “At the end of the day, monetary policy is not about interest rates,” said Greenwood. “It is about providing the right amount of funding or the right amount of money.”
Greenwood believes that the right response to prevent a negative spiral would be for the Fed to supply liquidity to deal with the panic – through purchasing bonds and Treasury bills, repo transactions, or by increasing the amount of US dollar swaps available to the central banks of Japan, China, Korea, Taiwan and Hong Kong. After the panic is over, the liquidity can be withdrawn so that it does not leave an excess funds in the market that might later generate inflation.
“The coronavirus pandemic is a short-term problem which need not tip the global economy into a recession,” said Greenwood. “But central banks need to adopt the correct strategy quickly to reduce the stress in the economy, and lead to a sustainable recovery in the summer.”
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