March 20, 2020

Coronavirus (COVID-19) Central Bank Policy Response

AUTHOR

Financial Keys

POST SUMMARY

Some of you may have seen or heard of the recent policy action from central banks around the world in response to the significant economic and market impact caused by the response to control the spread of the virus.

Some of you may have seen or heard of the recent policy action from central banks around the world in response to the significant economic and market impact caused by the response to control the spread of the virus.

The central bank response is one of the biggest stimulus packages we’ve ever seen and the right response in these trying times. Unfortunately, the response may have come about 2 weeks too late, with central bankers failing to heed warnings and learn from the mistakes made in the past in terms of acting too late. Potentially, a lot of the extreme market events we’ve seen in the last 2 weeks could’ve been lessened or softened if they had acted ahead of time.

The delayed response, whilst now showing signs of assisting markets in functioning more appropriately, will most probably mean they will need to provide even more stimulus at some stage over the next few weeks. The recent response, if levied 2 weeks ago, might have been sufficient.

In addition, governments may have been too slow to provide fiscal stimulus. Those that have provided stimulus, i.e. the Australian government, may have provided too little. Whilst the amount of stimulus required is largely guesswork from here, those more informed are landing at a required amount of approximately 20-30% of GDP (economic growth). To put that in perspective, for the Australian government, that would mean a package of $380 billion to $570 billion of fiscal stimulus, whilst for the US government, it would mean a package of more than US$4 trillion. That number is unlikely at this stage with the most recent reports indicating US$1-1.2 trillion which would involve US$500bn in direct payments to US citizens.

Coming back to the central bank response, a lot of it is quite technical, but the main point of it is to:

  1. Prop up the banking system so that they can extend credit to businesses and households
  2. Provide a significant positive liquidity shock to global bond markets
  3. Ensure bond yields remain extremely low in order to lower funding costs for banks and non-bank corporates.

Below is slightly more detail, which we hope is a fairly easy to understand summation of the policy response we’ve seen to date:

RBA (Australia)

  • Cut in the cash rate to 0.25% and almost a promise (technically called “forward guidance”) to keep rates at these levels for an “extended” period of time (read that as at least 2 years, if not longer). The cut was mostly psychological in that the big 4 banks can’t pass on the rate cut at these low levels.
  • Effectively “fixing” the 3 year Australian government bond yield at 0.25% by going into the market and buying/selling as many bonds as required to get the yield at that level – a form of quantitative easing or money printing.
  • Strengthening the banking system and providing support for credit to businesses, especially small to medium-sized businesses. Part of this involves fixing the 3 year bond rate at 0.25% which makes it significantly cheaper for the banks to lend money. The other part involves providing a line of credit at 0.25% interest to the banks to then on-lend to Australian businesses and households to support them through this time.
  • Ensuring the banks still earn interest on their deposits with the RBA, which would otherwise have fallen to 0% interest without their intervention.
  • Continuing to pump extra liquidity into the banking system via regular daily operations on an as needed basis, to ensure liquidity is maintained.

The Fed (US)

  • Cut their interest rate to 0% with forward guidance that it will remain at 0% long after the virus concerns begin to moderate
  • US$700 billion of money printing to step into the market and buy bonds (both government bonds and mortgage securities) to provide liquidity, with the buying likely to be front-ended (i.e. buy a lot of bonds daily early on)
  • They stopped short of intervening in credit markets as that would’ve involved the US government, but they still may have to intervene at some point if the other measures aren’t enough to stabilise the bond markets, especially as it pertains to corporate borrowing costs.

ECB (Europe)

  • Spending 750 billion EUROs by stepping into markets and buying bonds in order to provide liquidity and encourage government bond yields to fall.
  • This is in addition to the very weak response from the ECB last week to buy just 120 billion EUROs.
  • The ECB didn’t cut their interest rate as it remains below 0%, i.e. a negative rate.

Both central banks and governments now need to stand together and provide support – support to businesses, support to households, and support to investment markets. You can’t have “lock-down” with no support. We expect that support to be forthcoming.

As such, whilst we can’t yet say we’re through the worst of this from an investment market perspective, we do believe those support measures will mean we’re through the most of it.

Parting comments:

  1. Remain calm, don’t panic – panic involves irrational decision making and irrational decision making almost always results in a permanent loss of wealth
  2. Whilst some might have negative views of both governments and central banks in terms of their poor communication skills and/or their delays in acting. They do always come through.
  3. Avoid touching your face with your hands – the majority of virus transmission to date has been from hand to mouth, hand to nose, and hand to eyes contact. If you’re unwell, stay home, as should normally be the case. And please wash your hands before you handle food.

As always, please contact us at any time to discuss your investment portfolio or financial strategy. 

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