Dollars and Sense

Financial Markets Lean On Central Banks To Mitigate COVID-19 Fallout

Beata Caranci, SVP & Chief Economist | 416-982-8067

James Orlando, CFA, Senior Economist | 416-413-3180

Date Published: March 5, 2020

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Highlights

  • The spread of COVID-19 has shook financial markets. Equity indices have retraced about 15% from their peaks in late February, and government bond yields have fallen significantly on the repricing of policy rate expectations by major central banks.  
  • This week the Federal Reserve held an emergency policy meeting where it cut the fed funds rate by 50 basis points. The Bank of Canada has followed this lead with a 50 basis point cut, which surprised markets given the Bank’s recent hesitation to easy policy in the face of weakening economic growth. 
  • The easing of policy rates and potential for fiscal stimulus are necessary in order to cushion the hit to economic growth due to the virus. There is significant growth at risk and the economic buffer in many economies is thin. 
  • Though this is a supply-side shock at its origin, a persistent undermining in sentiment can have demand-side impacts. This is where central banks have historically been quick to help. We expect further interest rate cuts by the Federal Reserve and the Bank of Canada at their March and April meetings, respectively.  
  • Central bank action to ease policy and ongoing uncertainty around the virus will keep sovereign bond yields, mortgage rates, and corporate borrowing costs at extraordinary low levels.  
Chart 1: Equity Markets Rolling Over on COVID-19After the Group of Seven (G7) finance ministers made a unified statement that they are in a ‘ready to act’ position in response to the global COVID-19 outbreak, the Federal Reserve surprised markets with a 50 basis point cut to its policy rate. This impromptu meeting was unconventional but highlights the rapid shift in conditions over the past week, as confirmation that measures to contain the virus within China had failed. There are now over 80 countries with reported cases, some experiencing large-scale outbreaks. The broad reach creates greater opaqueness around potential global production and supply chain disruptions. Furthermore, market fear of this supply-side shock can morph into a demand-side shock if cautious behavior embeds deeply and persistently to undermine household and business confidence. The increased desire to save could trigger recession-like outcomes for countries that already sit on a thin growth cushion, resulting in deeper scars to the global economic landscape. Forward looking financial markets have responded to this potential economic loss with a strong risk-off move (Chart 1).
Last week’s rapid sell-off in equity markets is a demonstration on how quickly the foundation under sentiment can erode. It was less than two weeks ago that the S&P 500 hit an all-time high. In just seven trading days the Index declined approximately 15% peak-to-trough. Though the speed of the decline has been anomalous outside of recessions, the current sell-off from the peak is right around what typically occurs in any given year (Chart 2). For equity markets outside of the US, the drawdown started earlier, but has been just as pronounced.

The Safe Haven of the Bond Market

The Treasury market has been the biggest beneficiary of the risk-off environment. The UST 10-year has declined from 1.92% at the end of 2019, and is now below 1% today (Chart 3). This is reminiscent of the approximate 1% decline in response to the escalation of China-U.S. trade tensions last spring/summer. During that time, the expectation was that the Federal Reserve would respond to the economic risk by cutting interest rates. It did just that by cutting the policy rate by 75 basis points over three successive meetings from July to October 2019. The Federal Reserve’s current response is even quicker and reminiscent of efforts to sure-up markets during past recessionary episodes. Money markets are expecting further action that would bring the policy rate well below 1%.

Chart 2: The Equity Drawdown So Far Chart 3: Treasury Yields Falling on Expectations of Fed Rate Cuts

The Federal Reserve has shown a willingness to act when there are sustained deteriorations in market sentiment or deviations in global conditions from their expectations.  Members of the Federal Reserve have been especially attuned to signals coming from the bond market.  Even with the rate cuts this week, the yield on the UST 10-year is still below the effective fed funds rate. This inversion of the curve signals that investors think the Federal Reserve’s policy rate is too high given the current economic environment.  

Our baseline view is that the Federal Reserve will cut the policy rate again at its scheduled meeting in March and look to see how the virus has evolved before cutting again at its meeting in late April. It is important to note that the U.S. economy continues to rest on a solid foundation, consistently outperforming peers by a wide margin. Any response to cut interest rates is to address the sentiment channel, not to address a clear-and-present danger on real economic activity. 

The Bank of Canada has mirrored the response of the Federal Reserve with a 50 basis point rate cut this week. We expect it will continue to follow the Fed and cut again in April. We were pleased to see the Bank of Canada take such strong action in the face of such a large economic risk. Global growth estimates have deteriorated significantly, and the economy will suffer the sizable income shock from plummeting commodity prices. Even without an outbreak within a large urban center, economic activity will be whittled away through more cautious behavior to travel and attend activities. Their growth-at-risk framework argues for further cuts in the policy rate. 

The Impact of Easier Monetary Policy

Let’s face it, monetary policy is far more limited in addressing supply-side shocks, as we’ve noted in a recent report. Rate cuts will help ease debt service costs, which is meaningful given high debt loads. But it’s unlikely to light a fire under the economy. The biggest near-term benefit occurs through the sentiment channel. The “do whatever it takes” mantra of central bankers over the last three decades has supported investor confidence. Knowing that central banks will make efforts to stabilize the economy raises the probability of a quick recovery once the shock recedes. This also raises the probability that investment in risk assets will prove more profitable. In this way, central bank support can ease market tensions, to allow other areas of the economy to stabilize under the benefit of time or action of fiscal mechanisms. Our forecast for cuts to policy rates means that sovereign bond yields, mortgage rates, and corporate borrowing rates are all likely to hold lower.

Chart 4: Volatility Elevated Most in Equities

Just How Stressed Are You?

When we run our financial stress models, we find that market stress has risen from very low levels in early 2020, to a 1 standard deviation level today. The stress is most apparent in equity markets, with volatility at 3 standard deviations (Chart 4). This is greater than during the equity market sell-offs of 2018 and 2015, and comparable to levels during the European sovereign debt crisis in 2011. On the other hand, indicators of stress within corporate credit, Treasury, and money markets have been much more muted. This infers that investors are pricing a hit to corporate profits (hence the repricing in equities) but are not yet pricing significant business or consumer defaults. In fact, outside of the lowest rated corporate borrowers, bond yields are closer to historical averages than before the sell-off. The same goes for US equity valuations, where forward looking price-to-earnings ratios have gone from elevated levels at the end of January, to levels that are much closer to historical averages today. In this way, it appears equities may have been primed for repricing.  

Bottom Line

The spread of COVID-19 outside of China triggered a significant risk-off move in financial markets. Based on the information we have right now, our baseline view is that the economic fallout from this shock will reduce US and Canadian economic growth by about 0.5% to 0.7%.  This number will grow based on the extent of the virus’ geographic spread and whether fear changes peoples’ day-to-day pattern (spending). With equity markets having corrected 15% last week, a significant economic shock was priced. Same goes for fixed income markets, where expectations for even lower policy rates has pushed bond yields lower. 

The truth is that we don’t know how bad this will get. What we do know is that some amount of economic growth is already at risk and supporting market confidence is key to mitigating that depth. It is likely the Federal Reserve and the Bank of Canada will continue to cut rates at their upcoming meetings. Should the economic outlook materially worsen from expectations, the Federal Reserve has about 1% in interest rate cuts available and is open to implementing unconventional monetary policies such as Quantitative Easing. The Bank of Canada has 1.25% in cuts until the zero floor is hit. But, we don’t anticipate hitting either of these milestones. In a worst-case scenario, there’s little doubt that central banks and governments would join forces to leverage policy tools to cushion the shock. As seen globally, governments within impacted regions are acting swiftly on the fiscal front, and we expect no less in North America.

For our regular readers, we want to let you know that we are closely watching the evolution of the virus and assessing the economic impact of the events. We will be providing regular updates to make sure you are aware of any material changes to our outlook. 

To be continued…

Tables

Interest Rate Outlook
  Spot Rate 2019 2020 2021
  Mar-04 Q1 Q2 Q3 Q4 Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
CANADA                    
Overnight Target Rate  1.25 1.75 1.75 1.75 1.75 1.25 1.00 1.00 1.00 1.25 1.50 1.50 1.50
3-mth T-Bill Rate  1.14 1.67 1.66 1.65 1.66 1.02 0.90 0.90 1.02 1.27 1.40 1.40 1.40
2-yr Govt. Bond Yield  0.95 1.55 1.47 1.58 1.69 0.80 1.00 1.20 1.40 1.50 1.60 1.70 1.75
5-yr Govt. Bond Yield  0.90 1.52 1.39 1.40 1.68 0.80 1.10 1.30 1.50 1.60 1.70 1.80 1.85
10-yr Govt. Bond Yield  1.01 1.62 1.46 1.37 1.70 0.90 1.25 1.45 1.65 1.75 1.85 1.95 2.00
30-yr Govt. Bond Yield  1.31 1.89 1.68 1.53 1.76 1.20 1.40 1.60 1.80 2.00 2.10 2.20 2.25
10-yr-2-yr Govt Spread 0.07 0.07 -0.01 -0.21 0.01 0.10 0.25 0.25 0.25 0.25 0.25 0.25 0.25
U.S.                     
Fed Funds Target Rate  1.25 2.50 2.50 2.00 1.75 1.00 1.00 1.00 1.00 1.25 1.50 1.75 2.00
3-mth T-Bill Rate  0.71 2.35 2.08 1.84 1.52 0.85 0.85 0.85 0.98 1.23 1.48 1.73 1.98
2-yr Govt. Bond Yield  0.69 2.27 1.75 1.63 1.58 0.60 0.90 1.20 1.50 1.80 2.10 2.30 2.40
5-yr Govt. Bond Yield  0.78 2.23 1.76 1.55 1.69 0.70 1.00 1.30 1.60 1.90 2.20 2.40 2.50
10-yr Govt. Bond Yield  1.05 2.41 2.00 1.68 1.92 0.85 1.15 1.45 1.75 2.05 2.35 2.55 2.65
30-yr Govt. Bond Yield  1.70 2.81 2.52 2.12 2.39 1.50 1.80 2.00 2.20 2.40 2.60 2.80 2.90
10-yr-2-yr Govt Spread 0.36 0.14 0.25 0.05 0.34 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25
CANADA - U.S SPREADS                          
Can - U.S. T-Bill Spread 0.43 -0.68 -0.42 -0.19 0.14 0.17 0.05 0.05 0.04 0.04 -0.08 -0.33 -0.58
Can - U.S. 10-Year Bond Spread -0.04 -0.79 -0.54 -0.31 -0.22 0.05 0.10 0.00 -0.10 -0.30 -0.50 -0.60 -0.65
F: Forecast by TD Economics, March 2020; Forecasts are end-of-period.
Source: Bloomberg, Bank of Canada, Federal Reserve.
Foreign Exchange Outlook
Currency Exchange
rate
Spot Price 2019 2020 2021
Mar-04 Q1 Q2 Q3 Q4 Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Exchange rate to U.S. dollar                          
 Chinese Yuan CNY per USD 6.93 6.71 6.87 7.15 6.96 6.95 6.90 6.85 6.80 6.80 6.80 6.80 6.80
 Japanese yen JPY per USD 108 111 108 108 109 105 106 106 105 105 104 104 103
 Euro USD per EUR 1.11 1.12 1.14 1.09 1.12 1.09 1.09 1.10 1.11 1.12 1.13 1.14 1.15
 U.K. pound USD per GBP 1.29 1.30 1.27 1.23 1.33 1.28 1.28 1.30 1.31 1.32 1.33 1.34 1.35
 Swiss franc CHF per USD 0.96 1.00 0.98 1.00 0.97 0.97 0.97 0.97 0.97 0.97 0.97 0.97 0.97
 Canadian dollar CAD per USD 1.34 1.34 1.31 1.32 1.30 1.36 1.36 1.34 1.32 1.31 1.30 1.30 1.30
 Australian dollar USD per AUD 0.66 0.71 0.70 0.68 0.70 0.64 0.66 0.68 0.69 0.70 0.70 0.70 0.70
 NZ dollar USD per NZD 0.63 0.68 0.67 0.63 0.68 0.62 0.64 0.65 0.66 0.67 0.68 0.69 0.69
Exchange rate to Euro                          
 U.S. dollar USD per EUR 1.11 1.12 1.14 1.09 1.12 1.09 1.09 1.10 1.11 1.12 1.13 1.14 1.15
 Japanese yen JPY per EUR 120 124 123 118 122 114 116 116 117 117 118 118 119
 U.K. pound GBP per EUR 0.87 0.86 0.90 0.89 0.85 0.85 0.85 0.85 0.85 0.85 0.85 0.85 0.85
 Swiss franc CHF per EUR 1.07 1.12 1.11 1.09 1.09 1.06 1.06 1.06 1.07 1.08 1.09 1.10 1.11
 Canadian dollar CAD per EUR 1.49 1.50 1.49 1.44 1.46 1.48 1.48 1.47 1.47 1.47 1.47 1.48 1.50
 Australian dollar AUD per EUR 1.68 1.58 1.62 1.62 1.60 1.70 1.65 1.62 1.61 1.60 1.61 1.63 1.64
 NZ dollar NZD per EUR 1.77 1.65 1.70 1.74 1.67 1.76 1.70 1.69 1.68 1.67 1.66 1.65 1.67
Exchange rate to Japanese yen                          
 U.S. dollar JPY per USD 108 111 108 108 109 105 106 106 105 105 104 104 103
 Euro JPY per EUR 120 124 123 118 122 114 116 116 117 117 118 118 119
 U.K. pound JPY per GBP 138 144 137 133 144 134 136 137 138 138 138 139 139
 Swiss franc JPY per CHF 112.4 111.1 110.5 108.3 112.3 108.5 109.5 109.0 108.5 108.0 107.5 107.0 106.7
 Canadian dollar JPY per CAD 80.3 82.8 82.4 81.6 83.8 77.2 77.9 78.7 79.5 79.8 80.0 79.6 79.4
 Australian dollar JPY per AUD 71.3 78.6 75.6 72.9 76.4 67.2 70.0 71.7 72.5 73.2 72.8 72.5 72.3
 NZ dollar JPY per NZD 67.7 75.5 72.4 67.7 73.3 65.1 67.8 68.6 69.3 70.0 70.7 71.4 71.2
Exchange rate to Canadian dollar                          
 U.S. dollar USD per CAD 0.75 0.75 0.76 0.76 0.77 0.74 0.74 0.75 0.76 0.76 0.77 0.77 0.77
 Japanese yen JPY per CAD 80.3 82.8 82.4 81.6 83.8 77.2 77.9 78.7 79.5 79.8 80.0 79.6 79.4
 Euro CAD per EUR 1.49 1.50 1.49 1.44 1.46 1.48 1.48 1.47 1.47 1.47 1.47 1.48 1.50
 U.K. pound CAD per GBP 1.72 1.74 1.66 1.63 1.72 1.74 1.74 1.74 1.73 1.73 1.73 1.74 1.76
 Swiss franc CHF per CAD 0.71 0.75 0.75 0.75 0.75 0.71 0.71 0.72 0.73 0.74 0.74 0.74 0.74
 Australian dollar AUD per CAD 1.13 1.05 1.09 1.12 1.10 1.15 1.11 1.10 1.10 1.09 1.10 1.10 1.10
 NZ dollar NZD per CAD 1.19 1.10 1.14 1.21 1.14 1.19 1.15 1.15 1.15 1.14 1.13 1.11 1.11
F: Forecast by TD Economics, March 2020; Forecasts are end-of-period.
Source: Federal Reserve, Bloomberg.
International Interest Rates Outlook
  Spot Rate 2019 2020 2021
  Mar-04 Q1 Q2 Q3 Q4 Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Germany                          
ECB Deposit Rate -0.50 -0.40 -0.40 -0.50 -0.50 -0.60 -0.70 -0.70 -0.70 -0.70 -0.70 -0.70 -0.70
3-mth T-Bill Rate  -0.65 -0.55 -0.60 -0.61 -0.73 -0.65 -0.70 -0.70 -0.70 -0.70 -0.70 -0.70 -0.70
2-yr Govt. Bond Yield  -0.84 -0.61 -0.76 -0.78 -0.62 -0.75 -0.70 -0.59 -0.58 -0.54 -0.51 -0.46 -0.40
5-yr Govt. Bond Yield  -0.83 -0.46 -0.67 -0.78 -0.48 -0.75 -0.70 -0.60 -0.48 -0.44 -0.41 -0.36 -0.30
10-yr Govt. Bond Yield  -0.64 -0.07 -0.33 -0.58 -0.19 -0.60 -0.55 -0.45 -0.33 -0.29 -0.26 -0.21 -0.15
30-yr Govt. Bond Yield  -0.16 0.57 0.26 -0.10 0.31 -0.15 -0.12 -0.10 -0.08 -0.04 -0.01 0.04 0.10
10-yr-2-yr Govt Spread 0.20 0.54 0.43 0.20 0.43 0.15 0.15 0.14 0.25 0.25 0.25 0.25 0.25
United Kingdom                      
Bank Rate 0.75 0.75 0.75 0.75 0.75 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50
3-mth T-Bill Rate  0.46 0.75 0.75 0.77 0.70 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50
2-yr Govt. Bond Yield  0.20 0.64 0.68 0.36 0.54 0.25 0.20 0.30 0.42 0.46 0.63 0.75 0.85
5-yr Govt. Bond Yield  0.25 0.69 0.61 0.28 0.60 0.33 0.40 0.53 0.66 0.73 0.86 0.98 1.07
10-yr Govt. Bond Yield  0.37 0.99 0.83 0.40 0.73 0.40 0.60 0.75 0.90 1.00 1.10 1.20 1.30
30-yr Govt. Bond Yield  0.90 1.55 1.47 0.98 1.33 0.90 1.15 1.25 1.35 1.45 1.55 1.65 1.75
10-yr-2-yr Govt Spread 0.17 0.36 0.15 0.05 0.19 0.15 0.40 0.45 0.48 0.54 0.48 0.45 0.45
F: Forecast by TD Economics, March 2020; Forecasts are end-of-period.
Source: Bloomberg.
Global Stock Markets
  Price 30-Day YTD 52-Week 52-Week
  Mar-04 % Chg. % Chg.  High Low
S&P 500 3,130 -3.0 -2.8 3,386 2,743
S&P/TSX Composite 16,780 -3.1 -1.9 17,944 15,996
DAX 12,128 -6.6 -9.1 13,789 11,347
FTSE 100 6,816 -6.5 -10.2 7,687 6,581
Nikkei 21,100 -9.1 -11.5 24,084 20,261
MSCI AC World Index* 536 -4.0 -5.0 581 492
*Weighted equity index including both developed and emerging markets.
Source: Bloomberg, TD Economics.
Commodity Price Outlook
  Price 52-Week 52-Week 2019 2020 2021
  Mar-04 High Low Q1 Q2 Q3 Q4 Q1F Q2F Q3F Q4F Q1F Q2F Q3F Q4F
Crude Oil (WTI, $US/bbl) 47 66 45 55 60 56 57 51 49 56 58 58 59 59 60
Natural Gas ($US/MMBtu) 1.83 2.96 1.75 2.92 2.56 2.38 2.40 1.90 1.85 2.20 2.30 2.40 2.41 2.42 2.44
Gold ($US/troy oz.) 1637 1659 1271 1303 1307 1473 1482 1605 1675 1625 1575 1550 1525 1500 1475
Silver (US$/troy oz.) 17.22 19.60 14.35 15.58 14.91 17.02 17.34 17.70 18.50 18.00 17.85 17.75 17.65 17.50 17.25
Copper (cents/lb) 257 297 250 282 278 263 267 261 256 277 288 280 277 278 281
Nickel (US$/lb) 5.75 8.19 5.27 5.60 5.56 7.05 6.99 5.86 5.75 6.24 6.35 6.69 6.80 7.03 7.26
Aluminum (Cents/lb) 78 88 76 84 81 80 80 77 75 78 78 78 78 77 77
Wheat ($US/bu) 6.67 7.55 5.62 7.08 6.36 6.14 6.77 6.64 6.55 6.80 6.90 6.92 6.93 6.95 6.97
F: Forecast by TD Economics, March 2020; Forecast are period averages; E: Estimate.
Source: Bloomberg, USDA (Haver).

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