- Stock markets rallied on Tuesday and bond yields rose as markets reacted to the prospect of fiscal expansion in the US and Europe to prevent a credit crunch.
- Central banks are multiplying their interventions (cuts in key interest rates, asset purchases, operations to ensure market liquidity…) to relieve stress in financial markets.
Opening the public purses
Tuesday saw announcements from governments in Europe and the US that they are prepared to spend, and spend big, to counter the economic impact of the COVID-19 pandemic.
From the outset, it has been clear that COVID-19 affects both sides of the economy: supply and demand. The supply of goods and services is impaired because many factories and businesses are shut and output falls as a result. But demand also falls with many consumers confined to their homes and investment coming to a halt.
Conventional policy measures – such as cutting the cost of borrowing or reducing taxes – tend to work better when there is a demand shock. There is a limit to what they can do in the event of a combined supply and demand shock.
Hand in hand: fiscal and monetary policy action
However, monetary and fiscal policy, combined with regulatory adjustments, can prevent a financial crisis that could otherwise exacerbate the COVID-19 emergency. G7 governments are now committing to use their balance sheets to prop up business activity and protect household income.
This IMF exhibit illustrates the urgency of the situation: The rise in the risk premia on corporate bonds, the fall in equities and other extreme movements on the financial markets have spectacularly tightened financial conditions.
The US administration on Tuesday announced that a broad stimulus package would be proposed to Congress totalling as much as USD 1.2 trillion. That is equivalent to 5.5% of US GDP.
On Monday night, eurozone finance ministers pledged an ‘unlimited commitment’ to contain the economic damage and restore confidence. European Union fiscal rules are de facto being suspended for this purpose with a pledge to “make full use of the flexibility (of the rules) in all the member states”.
In Spain, Prime Minister Pedro Sánchez called for the “biggest mobilisation of resources in Spain’s democratic history” to fight the economic crisis, which is to include EUR 100 billion of state loan guarantees. The overall package is worth EUR 200 billion, or 15% of GDP.
In France, the government approved a EUR 45 billion rescue package, pledging an array of measures, including guarantees on EUR 300 billion of bank loans to businesses to ensure they do not collapse for want of liquidity. Collectively, eurozone members offered EUR 1 trillion in such national guarantees.
The German government announced last Friday that up to EUR 500 billion in loans would be made available to corporate Germany. In addition, there will be an expansion of a programme of export credits and other guarantees. Companies will be allowed to defer tax payments. A government-subsidised scheme is to be increased to compensate workers laid off during an economic crisis. Some regional administrations are financing funds to buy stakes in struggling companies.
Markets welcome the moves
Financial markets initially responded positively to the signs of collective fiscal action.
After a 12% fall on Monday, the US S&P500 equity index finished up 6% on Tuesday (see Exhibit 1)...
while the EuroSTOXX 600, which fell by 4.9% on Monday, rose by 2.4% (see Exhibit 2)...
and US Treasury and German government bond yields rose as markets anticipated a rise in issuance to finance government spending (see Exhibit 3).
Source for all three exhibits: Reuters, BNP Paribas Asset Management as of 18/03/2020
Markets were also reassured by the US Federal Reserve’s measures to stabilise the market for commercial paper and providing an extra USD 500 billion to support the overnight lending market.
However, at the opening in Europe this morning, markets are again falling. This likely reflects the ongoing uncertainty about the outlook for the pandemic and the extent and length of the subsequent recession.
Also read: Quality stocks remain our focus amid the volatility and listen to: Market weekly – quality is now key
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