Could they? And even if they could, should they?


ref: - "Investors expecting virus rescue by Fed ignore great risks”, Karen Petrou of Federal Financial Analytics, Markets Insight in the Financial Times

This particular coronavirus, Covid - 19, may be something new and so is its rate of spread and its threat to the global economy. Over the last 10 days of February investors finally and belatedly woke up to the reality of it all, dumped equities and piled into the safe havens we know so well… particularly US Treasuries where the 10yr yield made a startling new record low of 1.03%. But some things never change it seems, and amongst those we must number investor expectations that central banks will ride to their rescue. Promises from central banks across the globe over the weekend to do what's required were enough to encourage a sharp bounce in equities and oil markets yesterday, whilst that 10yr yield now trades at 1.17%.

Ever since then Fed Chairman Alan Greenspan seemed prepared to offer protection to investors by his readiness to support markets by easing monetary policy in difficult times -- okay, he would say they were moves to support the economy -- many investors have retained the belief that central bank policy to some degree at least is framed for their benefit. Of course, any central bank should look to quash the possibility of market crashes and the economic damage that they can cause. But very often it's the blinkered buying enthusiasm (over-exuberance?) encouraged by the belief in a safety net provided by monetary policy that promotes the hugely overstretched valuations that make serious price reversals more likely.

Commentators regularly, and central bankers occasionally, remind us that protecting investors is not one of a central bank's specific roles, and protecting the wilder speculators is DEFINITELY not their job. Remember, these later buyers were forcing stock indices up to repeated record highs well after Covid - 19 was well established, presumably in the belief that because China looked to be exerting a measure of control on the situation then the chances of a global pandemic were much reduced. That was a risky trading decision that may well prove to be a bad one, but you shouldn't expect either central banks or anyone else to bail you out if it all goes wrong. They will do what they reasonably can of course, but that doesn't mean that they won't be under huge pressure from politicians do more. The most predictable of all recent developments is Donald Trump calling for a BIG rate cut… but then if you're a president who thinks the success of his term in office should be judged solely on the level of the stock market you would, wouldn't you?

The issue of how much the central banks should be doing is one thing, but perhaps more to the point is the question of how effective any measures would be… and we're not just talking about how little ammunition central banks have got left in their arsenal. One crisis always varies a little in nature from another, but in this instance, it is fundamentally and absolutely different to what has come before. In 2008 we saw the Financial Crisis, and without being overly simplistic the clue was in the name: it was financial in nature, and the Fed (amongst others) was able to calm markets by using its financial weaponry. Coronavirus however is of course not financial but biomedical in nature, and the risks that it brings attack a different side of the economic equation: the supply side, as opposed to demand.

One can see why easier monetary policy might be the way to stimulate demand if that is your problem, but when breaks in supply chains result in shortages and service-sector disruption, why would anyone think that rate cuts and cheaper money would make any difference?

It would also be as well to remember that there is a real and physical element to the current threat, that of CONTAGION -- real contagion that is, not just in the market sense. If punters are too wary to fill shops, restaurants and hotels, or too afraid to fly or take public transport, are they going to change their thinking just because of a few bucks off their credit bill? Would you?

Ms Petrou is not saying that market meltdown is inevitable… at least we don't think she is… just that relying on central banks to turn it round is not realistic in this case. And even if somehow some drastic Fed action for example was to be effective, it would come waving two huge warning banners. Firstly, it will not work for long and would rely on a swift biomedical resolution. And secondly… and we're back to not what they could do but what they should do… if the Fed was seen be offering some kind of safety net beneath equity prices, it would confirm to some investors that "moral hazard is the defining market principle of the post-crisis era"

Moral hazard… the lack of incentive to guard against risk where one is protected from its consequences. Whether or not you agree that there is little that central banks can do in these circumstances, perhaps the greater worry is this: if investors come to believe that central bank support means that they will not suffer from the results of their (bad) decisions and that equity prices are too high to fall in the same way that banks were too big to fail, the door is open to crises in the future of epic proportions.

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