At the end of February, after a week that saw stock markets around the world plummet, US Federal Reserve chair Jerome Powell sought to calm fears, saying that the Fed would “act as appropriate” to support growth. 

A day later, China posted a record low Manufacturing Purchasing Managers’ Index (PMI) figure, 15 points lower than the previous month. This was far lower than forecast, and dragged down an otherwise steady global manufacturing PMI aggregate to an 11-year low.

The quarantining of Italy’s entire population has demonstrated the worrying speed with which the situation is changing. With OPEC+ oil producers unable to reach agreement on supply cuts to support the crude price, oil’s potentially worrying weakness adds to the ingredients for an apparently perfect storm.

Central banks have been cutting rates and generally easing policy, though Powell cautioned that easing monetary policy “will not reduce the rate of infection, and it won’t fix a broken supply chain”. 

However, the magnitude of this supply shock and the difficulty in predicting or quantifying the spread of Covid-19 are contributing to a sense that it is not just Chinese consumers who are having to dramatically reduce their spending. Demand may be severely hurt throughout the world. 

As Bank of England deputy governor Jon Cunliffe points out: “In a disruptive shock, you won’t know what is supply and demand for some time.” The worry for the US economy, and for the rest of the world, will be whether the indomitable US consumer decides to rein in spending too, thus endangering that economy’s strongest prop.

Is the Japanese yen still a safe haven?

In times of capital-market anxiety and uncertainty, the search for a safe haven becomes ever more pressing. 

Indeed, gold has had a good run over the past few months, benefiting from its ‘traditional’ safe haven status, and from the increasing stock of negative yielding assets throughout the world, which has made holding zero-yielding gold a rather more attractive proposition.

The yen has, for decades, been viewed as somewhere safe in times of strife, tending to appreciate as riskier asset prices have declined. Though there is no perfect safe haven, there have been growing arguments questioning the yen’s reputation and ability to perform as a safe haven under any circumstances.

In mid February, the dollar-yen rate spiked up to 112, after trading in a narrow range for much of 2019. In seeking to explain why the yen was not behaving as a safe haven, analysts were quick to point to Japan now running a trade deficit; or to domestic investors – including the managers of the world’s largest pension fund, the $1.6trn Japanese Government Pension Investment Fund (GPIF) – buying more (unhedged) foreign assets; or to Japanese corporates embarking on huge M&A in and around China. 

With the oil price dropping, and no let-up in negative Covid-19 news, yen weakness then switched to yen strength, the dollar-yen rate declining about 9% in a fortnight, and taking the yen to its strongest level versus the dollar since October 2008. 

A strong, and unsurprising driver over this period was undoubtedly the rapid narrowing in the spread between 10-year US Treasury yields and 10-year Japan government bond yields. 

While the dollar-yen pair is prone to bouts of decoupling from its normal drivers, such as interest-rate differentials, doubts are lingering as to whether its safe haven status is sustainable. 

Portfolio outflows, particularly from the GPIF could – at the very least – dampen the effects of capital inflows. 

Until at least some of the world’s tensions have lessened, these currency-weakening dynamics may not yet manifest themselves. 

Bonds

US Treasuries have moved so dramatically, as if the economy had actually moved into recession. Though the Fed is less constrained by the lower bound than its European or Japanese counterparts, some are arguing that Fed rate cuts will not be enough and that rates are already pricing in the next round of quantitative easing.

Some analysts are not surprised that the S&P 500 has fallen through support lines at the same time as the Fed’s balance-sheet expansion ended. The increase in assets seen over the last quarter of 2019 was in response to the liquidity problems in the funding/repo markets.

The US yield curve steepened when the Fed cut 50bps, which is what the curve tends to do in such cases, and the move was particularly dramatic, given this was the first unscheduled emergency rate cut since the dark days of 2008.

Over the past three decades, a bull steepening has generally led to government bonds performing well in both equities and credit. Both dollar and euro credit have already suffered huge spreads. 

The general uncertainties about the nature of the current shock, concerns about the ability of corporates lower down the credit ladder to withstand a big demand shock, as well as the inefficiencies of effectively hedging credit portfolios, all point to a difficult time for credit, with valuations still relatively high.

Looking back at previous emergency rate cuts – after the 9/11 terrorist attack and subprime crisis in 2007-08 – the cuts themselves did not necessarily provide the panacea that stressed markets required. Today might be no different, although the Fed and other central banks, having enacted monetary policy, will now look to the politicians to provide some sort of fiscal response to allay fears and limit economic damage.

Currencies

The magnitude and speed of moves within the foreign exchange markets have been quite distressing. These large, and sometimes indiscriminate, drawdowns, particularly within the high-yielding emerging market and commodity currencies, occurred as investors sought to cut asset exposures and their foreign-exchange overlays, as plummeting confidence and soaring volatilities dangerously alters value-at-risk (VaR) calculations and assumptions.

With the unwinding of so many carry trades, low-yielding currencies like the euro, yen and Swiss franc have benefited. The trade-weighted dollar index (using the DXY index) has fallen significantly since mid-February when it reached a multi-year high of 99.86. This decline masks two opposing trends; up against embattled emerging-market (EM) and commodity currencies and down significantly against low yielders. 

Although interest-rate differentials have moved against the dollar, with US Treasury yields hitting record lows, the currency still enjoys a degree of safe-haven status which, coupled with the relative strength of the US economy, and the (worrying) lack of liquidity in markets, suggests that it could keep its bid for now.

The dramatic slump in the oil price is worrying, and has the potential to add to the economic damage caused by Covid-19. Though it will be EM oil exporters that are most at risk, it further hurts confidence in all EM assets, in an environment where EM sovereign spreads are at their widest level in 10 years. 

Increasing risks of downgrades and defaults further raises the prospect of worsening financial distress in markets that are already suffering from liquidity problems. Risk premia on all EM assets could rise further.

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