March was when the markets froze up. Many, including myself, thought closing the markets was possible as has been done during other big shocks and without jeopardizing the reputation of exchanges or officials. Central banks and governments around the world began responding in earnest to the impact of economic shutdowns and market disruptions. The MSCI All-Country World Index (ACWI) bottomed on March 23. So did the S&P 500, while Europe's Dow Jones Stoxx 600 bottomed a week earlier (March 16), and the MSCI Asia Pacific Index recorded its low a couple of days later (March 19).
April was about further policy response. Efforts were increased in terms of size, scope, and/or time. Officials were successful in removing the far left-hand tail risk. Punishing volatility in the markets eased. Stress in the funding markets relaxed. The compression of demand, supply chain disruptions, the contagion in the US meat processing industry, and some peculiarities with the settlement of the deliverable futures light sweet crude oil contract, distorted the commodity prices. The negative oil prices were quickly reversed and were near $20 a barrel by the end of the month.
The first half of May was characterized by the main equity markets consolidating the previous month's strong bounce. None of the major benchmarks (cited above) rose above the highs set in late April. The dollar had weakened against most of the major currencies in April (except the euro and Swiss franc) and strengthened in the first part of May. The lack of a strong EU response and a German Constitutional Court ruling made it more difficult for the ECB to keep the peripheral premium from widening over Germany and throwing a spanner into its transmission mechanism.
May is when the high-income economies may hit a trough as many countries begin relaxing their lockdowns. Of course, the difference between relaxing lockdowns and economic recovery may be quite stark, but the first thing that happens is that contractions slow and stop. In the monthly cycle of high-frequency data, the first evidence will likely be seen in soft data like surveys, like the Empire State Survey released at the end of last week. It rose from a catastrophic -78.2 in April to a horrific -60.0 in May.
The data highlight of the week ahead will be the preliminary May PMI reports. Marginal improvement is generally expected, and we will see if the underperformers are punished. The Philadelphia Fed's manufacturing survey and Germany's ZEW investor survey will also provide tests of the hypothesis.
The idea of a "V" recovery has long been abandoned, though apparently it still makes for a good foil. Still, imagine what a chart of growth will look like if, after a dramatic contraction in Q2, the economy is flat Q3. Alternatively, the idea of a "K" bottom has much to commend itself. It recognizes that as often is the case, economic and financial pre-conditions matter in determining who can take advantage of the opportunities the fluidity of events creates.
It does not mean that more stimulus will not be needed. Federal Reserve Chairman Powell was pretty clear on the need just as the House Democrats drafted the fourth fiscal response, assembling a $3 trillion package. Despite the record refunding and the new supply that should be anticipated, US rates, 10- and 30-year yields, fell last week (four and seven basis points, respectively). On May 19, both Powell and Treasury Secretary Mnuchin testify before the Senate Banking Committee. A bipartisan group of Senators wants the Fed to buy long-dated local government bonds. Currently, the Fed does not purchase muni bonds with maturities greater than three years.
In fact, the recovery itself may need new spending, not simply replacing lost incomes during the shutdown. Europe may again move to center stage next month as the EU plans for a recovery effort are expected to reach fruition and ECB loans (TLTRO) that could have a yield as much as minus 100 bp if certain lending criteria are met. Also, as early as next month, the ECB could extend its Pandemic Emergency Purchase Progam. Though it need not be in a hurry, it would likely have to be done by late Q3. The Bank of England's new governor, Bailey, hinted that its asset purchase program may be extended next month as well.
Some of the Federal Reserve's programs are only now coming into operation. Still, it is making small, seemingly frequent adjustments. It is dropped the three-month repo operation, for example, as the market showed little interest. The Fed has also reduced its Treasury purchases to a $6 bln a day, down from a peak of $75 bln a day. The Reserve Bank of Australia has slowed its bond purchases, while the Bank of Japan is buying fewer ETFs and REITs.
Governor Bailey at the Bank of England, the new Bank of Canada Mecklem, and several Fed officials, including Powell weighed-in against negative interest rates. Nevertheless, the UK 2-year bond yield finished the week with an implied yield of less than zero, In the US, beginning with the March 2021 contract, the fed funds futures strip is also implying slightly negative rates. In the US, this seems peculiar to the futures contract. The more liquid Eurodollar futures do not show negative rates, and the US 2-year yield has been gyrating in the trough between 10 and 20 bp for a couple of weeks. The Reserve Bank of New Zealand explicitly kept negative rates on the table, and its 2-year yield was halved last week to six basis points. What the RBNZ did was double its bond-buying program.
In addition to the economic data, two events could usher in a new phase in the US-China rivalry. The first is the World Health Organization pandemic conference. While the substance is obviously important, there is an important subtext. Will Taiwan be given observer status as several countries, including the US, have vocally advocated over Beijing's objections? The Wall Street Journal called it a "test of America's leverage in its broader political struggle with China." Even if this is hyperbolic, as Taiwan's success in combatting the coronavirus is noteworthy in its own right, it may suggest a greater willingness to go against China's wishes, even if it means retaliation (e.g., Australian barley and beef sanctions).
The second event is the National People's Congress at the end of next week. It will likely provide formal support for additional fiscal and monetary support for the economy. The event is also important because it may clear the deck, so to speak for the US to issue several reports. The Treasury's report on the foreign exchange market was due last month, and while there have been some more pressing matters, it is expected in the coming weeks. While the dollar is holding above CNY7.0, whose penetration was cited by the US when China was labeled a currency manipulator (and then reversed itself), so clearly took the veneer off the primarily political judgment as to render it of little strategic value. In any event, after weakening in March, alongside nearly every other currency against the dollar, the yuan has been trading quietly in range.
Also, soon the State Department will issue its evaluation of Hong Kong's autonomy. If it is not affirmed, Hong Kong will lose its special trade privileges, which exempt it, for example, from the tariff on the mainland products levied by the US. This seems like a strong measure, and it may not be used at this, the first opportunity. As the recent arrests of some of the leaders of the protests demonstrate, however, Hong Kong officials are repressive in their own right. Meanwhile, a bill is making its way through Congress that empowers the president to sanction individual Chinese officials for human rights violations, where the treatment of Uighurs has been a catalyst.
Tensions with China are likely to rise in the weeks and months ahead. This seems to be typically the case at this point in the US political cycle. Last week, the US granted a 90-day extension of its temporary reprieve from the ban on using Huawei equipment. It is difficult to know if the reprieve will be extended again, but the purpose is to facilitate a transition away from Huawei. At the same time, the US blocked global chipmakers from supplying Huawei, and some retaliation by Beijing seems likely, albeit asymmetrical. In the context of other official US rhetoric, fears of an escalation of tensions may throw a spanner into risk appetites.