Bond Market, China GDP May Reverse Risk Sentiment

Market confidence waned after the best week in decades, USD/JPY may continue to move lower.

US stocks soared last week to post their biggest weekly gains since 1974, extending a remarkable rally despite evidence of increasing levels of economic strain due to the coronavirus pandemic.

Markets charged higher much of the past week, helping the shares of everything from banks, manufacturers to hotel operators to chip away at their losses.

The frenzied rally stood in sharp contrast to dim news on the health of the economy. Thursday’s data showed that the number of Americans who applied for unemployment benefits in the first week of April was 6.6 million, as swaths of the US economy shut down because of the coronavirus pandemic. In a recent report, the Congressional Budget Office said it expected the US unemployment to rise by more than 10% in the second quarter, despite lawmakers enacting stimulus measures recently to try to offset the pain stemming from a nationwide disruption to business.

Here’s one of the reasons why stocks have proved to be more resilient than expected: Central bankers have stepped in to provide unprecedented levels of support for the economy. The Federal Reserve unveiled new programs on Thursday to provide USD 2.3 trillion in lending, expanding efforts to reach small and midsize businesses, as well as cities and states. The central bank also said it would expand its corporate lending programs to riskier types of debt that had previously been excluded.

However, bond-market volatility has dropped dramatically, sending a positive signal for the US stock market. A measure of bond-market volatility known as the US Bond Market Option Volatility Index recently hit the lowest level since early February, before US stocks entered a bear market and fears of a recession intensified. The measure jumped dramatically during the market turmoil in March and has now receded to average levels over the past decade.

Meanwhile, the CBOE Volatility Index, a measure of stock-market volatility, closed Thursday at 41.67, well above the average level of roughly 18 that the index has recorded since 2009. On March 19, both indexes were near their highest levels in history. The drop in bond-market volatility compared with stock volatility has happened previously and tends to be followed by strong stock returns, that was the case in February and December of 2018.

This relatively rare condition of intense stock market fear, combined with a generally calm bond market, has proven to be a powerful combination for ensuing stock-market returns.

It is a sharp shift from last year, when measures in the bond market were flashing red while stock-market volatility receded. For example, a widely followed bond-market signal known as the yield curve was also indicating that a recession was on the horizon.

US job market facing the risk of “hysteresis”

The novel coronavirus crisis has pushed millions of Americans out of work and it will lead to millions more layoffs before it has run its course. The sooner all those people get back to work, the better. The danger is that many of them won’t be returning to the workforce anytime soon.

The Labour Department on Thursday reported that the number of US workers filing new claims for jobless benefits last week came to 6.61 million, only marginally lower than the record 6.87 million a week earlier. Continuing claims, or the number of people receiving regular benefits which are reported with an extra week’s lag, rose to 7.46 million in the week ended March 28. That exceeded the May 2009 record of 6.64 million, a level that took months of post-financial crisis job losses to reach.

What is happening is, in all ways, unprecedented. Never before has America’s labour market been hit as hard and quickly as this. Worse, in the weeks ahead as shutdowns and other social-distancing measures continue to take their toll on sales, more people will be laid off. As the people who have lost their jobs curtail spending, more workers will be at risk.

There is hope that the number of people dying daily from Covid-19 will soon crest in the US, and that the worst of the health crisis will soon be over. The widely followed Institute for Health Metrics and Evaluation epidemiological model, for example, suggests that Sunday will be the peak day for daily deaths, and that by the end of May the number of people dying daily from the virus will have fallen. But that model operates under the supposition that full social distancing will remain in effect until then, which is seven weeks from now. State and local governments watching such models are unlikely to let down their guard soon, so it will take some time before many people get called back to work.

Perhaps the biggest danger to the long-term health of the job market and the economy, is that many workers will end up being out of work so long that their skills erode to the point that they will struggle to find work even when business picks up again — a prospect that economists call “hysteresis.” Similarly, many graduates who would normally be starting jobs this summer will instead be spending what would have been an early, formative period of their careers without work.

What else the Fed can do

With a series of moves that take it deeper into uncharted waters, the Federal Reserve has shown that its work in supporting the economy through the coronavirus is far from finished. What additional steps the central bank will take still remains unknown.

But with its most recent measures, which include forays into small business loans and junk bonds, the Fed has displayed a whatever-it-takes willingness to use all the tools at its disposal, and come up with some new ones necessitated by an economic crisis the nature of which the US has never seen.

The Fed is at war against the virus and this is a wartime degree of commitment to credit policy.

Last Thursday, not only did the Fed announced details of the much-anticipated Main Street lending program it is undertaking with the Treasury, but also detailed a slew of other measures aimed at boosting various parts of the markets and economy.

There was a move to provide support for loans made to small businesses, another measure that adds to existing credit facilities that will buy up business debt beyond the investment-grade sphere and into “fallen angel” territory that includes recently downgraded companies, and a bold move to loan directly to states and municipalities.

Taken together, the programs are designed to add up to USD2.3 trillion in loans. That doesn’t even count the previous initiatives: Near zero interest rates, open-ended asset purchases that already have increased the Fed’s holdings by nearly USD2 trillion, and a host of other credit facilities aimed at everything from providing overnight financing for banks to ensuring the supply of US dollars to central banks around the world, a move that by itself has added more than USD300 billion to the Fed’s balance sheet.

The moves go beyond anything the Fed had done during the financial crisis in 2008-09, both in scope and speed. Market called it “an incredibly broad deployment of new generation virus era” programme that seeks to address the specific nature of the shock as it impacts financial markets and credit supply on an all-out war footing.

However, with all of these done, the tough work may be yet to come. The Fed has gone both bigger and broader if credit doesn’t become cheaper. Huge implementation tasks lie ahead. Market participants should recognize that it will be weeks – in some cases more than a month – before new programs are up and running.

The moves reflect a commitment from the Fed to attack the economic issues at their roots for a public that had a recession forced on it due to virus protection measures. For now, there’s little concern being expressed about consequences down the road. “Market undertaking these sacrifices for the common good, we need to make them whole,” Chairman Jerome Powell said Thursday. “These are programs that we’re developing at a high rate of speed. We don’t have the luxury of taking our time the way we usually do.” Despite a raft of horrifying economic data and even worse forecasts ahead, the stock market is coming off its best week since 1974.

With the outlook for unemployment and gross domestic product even worse than the financial crisis and approaching Great Depression-like numbers, investors have been willing to bet that the Fed’s historically aggressive stance will pull the economy back on its feet after the coronavirus crisis passes.

But still, there are challenges ahead. Enforcing the rules of the programmes will be difficult and the banks that will be making the loans may not be willing to do that on their own. And as the true nature of the economic damage becomes known, the Fed may be called on to do still more.

The central bank already has taken unprecedented steps out on the risk curve by agreeing to buy corporate debt at a time when S&P rating firm estimates that USD650 billion worth is in the at-risk category. Any further tumult could see a demand for the Fed to start buying equity ETFs, in the mode of what the Bank of Japan has been doing.

Still more damage might show that loans aren’t enough, particularly for smaller companies.

When we look at mid-caps, 85% of them are over-indebted. They don’t have debt because they invest, they have debt because they struggle. We think in 2-3 months’ time, we will know better how this will go. It will all depend on how long the US is closed, how big the output gap is. The larger the output gap, the deeper the economic damage.

US companies are indicating an increased interest in alternative finance, showing that “possibly the banks are tapped out.” The Fed is trying to step into that financing gap as it grapples with multiple challenges at once.

Free money is what the economy needs now, not a helping-hand loan that needs to be paid back. Fed officials need to be careful otherwise they may be loading up too much debt on US firms to weather the economic storm that the country will never be able to pay off and will drag down economic growth for years to come.

Time of reopening the economy remains unknown

President Donald Trump said on Friday that he will not reopen the economy “until we know this country is going to be healthy.”

The US Department of Health and Human Services reportedly projected that lifting stay-at-home orders, school closures and social distancing after just 30 days would lead to an infection spike this summer. When asked whether Trump had seen federal projections that the coronavirus could resurge if the 30-day shelter-in-place orders were lifted, he said he had not seen the projections.

Trump said he also plans to announce an “Opening Our Country Council” on Tuesday which comprised of business leaders, doctors and potentially governors that will help determine how to reopen the economy.

Dr. Anthony Fauci, White House health advisor, said that whenever governments begin to pull back restrictions, there could be a resurgence in new cases. The goal at that point would be to quickly identify new cases, isolate infected people and contact trace, or determine the origin of infection. “When we decide at a proper time when we’re going to be relaxing some of the restrictions, there’s no doubt you’re going to see cases,” Fauci said, “I’d be surprised if we didn’t see cases. The question is how do you respond to them.”

China GDP will be closely watched this week

China is set to report an epic contraction in 1Q GDP, underlining the blow from the coronavirus outbreak. Activity data for March should show the economy clawing back to its feet, though still depressed relative to pre-pandemic levels.

China’s March trade data are likely to show the external sector taking another beating before it was able to find a footing in the wake of the initial, domestic blow from the pandemic. Exports should be helped by increasing restoration of production. Leading indicators signal an expansion of the manufacturing sector from the previous month. The official manufacturing purchasing managers’ index rose to 52.3, above the 50-level dividing expansion and contraction.

The global economy has taken a sharp turn for the worse since the second half of March, with the spread of the virus and the implementation of increasingly stringent containment measures.

The weakness in these trading partners’ manufacturing sectors likely disrupted supply chains and dampened demand for China’s exports.

The domestic component of imports should be better off than it was in February. The gradual pickups in production and investment should give imports a lift. Imports related to processing trade are driven by the same factors that affect exports.

The contraction of China’s 1Q GDP is set to be on an unprecedented scale, unlikely anything the country has experienced since it started its economic reforms in the late 1970s. Our model shows GDP tracking about 15-20% below year-earlier levels in the first two months of the quarter, reflecting the blow from the coronavirus outbreak.

In March, the back-to-work rate following widespread shutdowns climbed steadily, reaching about 90% toward month-end, according to our estimates based on high-frequency data on people’s mobility, FX trading volume and commodity shipments. Increasing return-to-work rates likely benefited industrial production and investment, although both were still likely below normal levels.

The recovery in consumption was probably slower, given self-imposed social distancing. As such, GDP is likely to have continued to contract in March, albeit at a slower rate. China’s March activity data are likely to show the economy coming out an abyss, but still below its normal levels. The back-to-work rate edged up to around 90% in the final week of March, up from 70% at the beginning of the month. These are higher than the average of around 50% in February.

The pickup in production was captured by a significant movement in the official manufacturing PMI. It jumped to 52 from the historical low of 35.7, suggesting the manufacturing sector had expanded in March. The higher back-to-work rate will also lift investment. Public investment is expected to start to show the impact of government support. Consumption, proxied by retail sales, is likely to show less of a recovery than production and investment.

Our Picks

EUR/USD: Slightly bearish

The pair may fall towards 1.0920 this week

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