Pandemic Risk Rising

Doug Nolan

Coronavirus cases in China have surpassed 76,000. Deaths have reached 2,345. The number of new cases has slowed markedly, perhaps owing to repeated changes in the methodology of counting infections. Developments elsewhere are less encouraging. Plans have been drawn to add 19 temporary hospitals in Wuhan.

There are reported cases of Chinese being re-infected after hospital discharge. This week saw a surge in coronavirus cases in Beijing to 396. Two hospitals in Beijing were quarantined, as concerns of a rapid escalation mount. Infections are now spreading in multiple Chinese prisons. Twelve cases have been reported at a single Wuhan nursing home.

A Friday evening New York Times headline: “With 4 Deaths in Iran and More Cases on 3 Continents, Fears of Coronavirus Pandemic Rise.” Alarmingly, new South Korea coronavirus cases spiked to 142 on Friday. Cases quadrupled in two days and surged ten-fold in four (from Monday’s 30 infections). At 346, South Korea is now second only to China (excluding the Diamond Princess). A troubling Wednesday Bloomberg headline: “As Cases Mount, Japan Rapidly Becomes a Coronavirus Hotbed.” Cases tripled over the past week in Japan to 92.

Reported cases in Iran went from zero to 18 in three days. With four deaths, the number of infections could already number in the hundreds. Most are in Qom, but there has been an infection reported in Tehran. A member of the Iranian Health Ministry was quoted by the New York Times: “A coronavirus epidemic has started in the country.

It’s possible that it exists in all cities in Iran.” The United Arab Emirates now has 11 cases. Israel and Lebanon both recorded their first infections Friday. The World Health Organization is particularly worried about outbreaks unfolding in areas with inferior healthcare systems. Cases tripled to nine Friday in Italy, with the first death reported.

Friday from the New York Times (Vivian Wang, Donald G. McNeil Jr., Farnaz Fassihi and Steven Lee Myers): “Further bolstering the idea that the virus is spreading widely, an epidemiological modeling team from Imperial College in London estimated Friday that two-thirds of the people infected with coronavirus who left mainland China before restrictions were imposed had traveled throughout the world without being detected.”

The infection count from the Diamond Princess cruise ship now exceeds 600. It appears 28 infected American passengers have been brought back to the U.S. Forty seven infected Canadian passengers are being treated in Japan, while 129 Canadians having not yet tested positive flew back to Canada on Friday. Four Australians rescued from the Diamond Princess have tested positive, bringing the total to 46 Australians infected on the ship.

Friday evening from the Washington Post (Gerry Shih, Michael Brice-Saddler, Lateshia Beachum and Miriam Berger): “There are outbreaks. There are epidemics. And there are pandemics, where epidemics become rampant in multiple countries and continents simultaneously.

The novel coronavirus that causes the disease named covid-19 appears to be on the verge of that third, globe-shaking stage. Amid an alarming surge in cases with no clear link to China, infectious disease experts think the flu-like illness may soon be impossible to contain. The World Health Organization has not declared covid-19 a pandemic, and the most devastating effects… are still in China.

But the language coming from the organization's Geneva headquarters has turned more ominous in recent days as the challenge of containment grows more daunting. ‘The window of opportunity is still there, but the window of opportunity is narrowing,’ WHO Director General Tedros Adhanom Ghebreyesus said Friday. ‘We need to act quickly before it closes completely.’”

February 19 – Financial Times (Robin Harding and Alice Woodhouse): “The hundreds of passengers being released by Japan from the Diamond Princess posed an ‘ongoing risk’ of spreading the coronavirus, the US Centers for Disease Control warned as about 500 people began disembarking from the stricken cruise ship. The leading American public health institute said that attempts to quarantine the 3,700 passengers who were on board the vessel moored off Yokohama had been ineffective, after several hundred people on board contracted the infection. The warning from the CDC, which said it was imposing immediate travel restrictions on the ship’s passengers and crew, came as Japan… released some of the remaining passengers…”

As the trading week came to an end, cracks appeared to emerge in the irrepressible global market boom. Initial indications of de-risking/deleveraging were apparent at the emerging markets “Periphery.”

With coronavirus cases spiking, the South Korean Kospi equities index sank 3.6%. While Chinese stocks rallied this week, equities dropped 2.0% in Thailand, 1.5% in Vietnam, 1.1% in Taiwan and almost 1% in Malaysia. Stocks were down 2.8% in Turkey and 2.7% in Chile. Local currency bond yields jumped 83 bps in Turkey and 15 bps in Brazil and Chile.

The more intriguing moves were in the currencies.

Curiously, the yen sank a quick two percent in two sessions to trade to the low versus the U.S. dollar since April. The South Korean won dropped 2.15%, the Thai baht 1.55%, the Malaysian ringgit 1.28% and the Taiwanese dollar 1.21%. But it wasn’t just Asian currencies under pressure. The Brazilian real declined 2.21%, the Mexican peso 1.87%, the Chilean peso 1.41% and the Russian ruble 0.79%. Notable moves in “developed” currencies included losses of 1.38% in the New Zealand dollar and 1.30% in the Australian dollar.

I view heightened currency market instability as a harbinger of “risk off” de-risking/deleveraging. Increasingly volatile and unpredictable currency swings engender a risk-mitigating reduction in speculative leverage. This, on the margin, reduces marketplace liquidity while weighing on market prices. Such dynamics typically unfold at the “Periphery.” And it is the “Periphery” that happens to be increasingly exposed to Global Pandemic Risk.

The safe havens enjoyed a big week. Gold surged $59 to a seven-year high $1,643. Playing some catch-up, Silver jumped 5.0% to $18.613. Ten-year Treasury yields sank 12 bps to 1.47%, nearing the lowest yields since 2016. Swiss 10-year yields fell five bps to negative 0.76%, with bund yields down three bps to negative 0.43%.

While the moves were not dramatic, it is worth noting late-week reversals throughout the Credit default swaps (CDS) universe. After closing last week near lows going back to 2007, investment-grade CDS rose three bps to 46.6 bps. High-yield CDS jumped 10 bps to an almost three-week high 295 bps. EM CDS rose seven bps to 196 bps, the high since January 31st. Some of the bigger moves were in European high-yield. CDS for the big global banks also reversed higher. It’s also worth noting Japanese banks dropped 1.9% this week, with European banks down 2.3%.

Chinese January Credit data were out this week – and the numbers were gargantuan! Chinese lending surged in what is typically the strongest Credit expansion of the year. Aggregate Social Financing (a measure of total system Credit) surged a record $720 billion – for the month (history’s greatest monthly Credit expansion?). This was more than double December growth and 25% above estimates. Credit growth was 8% ahead of the previous monthly record from January 2019. This put one-year growth at almost $3.70 TN, or 10.7%.

New Bank Loans surged a record $475 billion, up from December’s $162 billion. Bank Loan growth exceeded the previous record – January 2019’s $459 billion - by about 3%. This put one-year growth at $2.408 TN, or 12.1%. Bank Loans expanded 27% in two years and 87% in five.

January’s Credit boom was driven largely by a surge in corporate lending – that, considering the backdrop, could be viewed ominously. Government lending was strong. Even “shadow banking” showed a pulse, reversing course for a marginal expansion during the month.

Curiously, Consumer (chiefly mortgage) Loans increased only $90 billion for January, the weakest growth since October. Monthly Consumer Loan growth was down 36% from January 2019. Still, two-year growth was at 35%, three-year at 64% and five-year growth of 137%.

February 16 – Reuters (Yawen Chen and Se Young Lee): “New home prices in China grew at their weakest pace in nearly two years in January as the economy slowed and a fast-spreading coronavirus outbreak brought the country’s property market to a standstill. Worryingly, analysts say the worst is yet to come for the property market, noting that with stepped-up measures to contain the spread of the epidemic, aggressive price-cutting by developers and widespread business disruption will be fully reflected only in coming months. Average new home prices in China’s 70 major cities rose 0.2% in January from the previous month…”

We’ll wait about a month for February Credit data, yet it would appear China’s housing markets had already begun a meaningful slowdown prior to the coronavirus outbreak. With apartment sales slowing dramatically, February Consumer lending volumes will be dismal.

How quickly apartment sales bounce back is a critical issue for Chinese finance as well as China’s economy. Increasingly, however, it appears that great uncertainty surrounds economic prospects for Japan, South Korea, greater Asia and the emerging markets, Europe and globally. The bullish hypothesis that the coronavirus would be largely limited to China and soon contained is increasingly suspect.

February 21 – Bloomberg: “China car sales plunged 92% during the first two weeks of February as the coronavirus outbreak kept buyers away from showrooms. It was even worse in the first week, when nationwide sales tumbled 96% to a daily average of only 811 units, the China Passenger Car Association said in a report released earlier this week. Deliveries this month may slide by about 70%, resulting in a roughly 40% drop in the first two months of 2020, the association said.”

And Wednesday from CNN (Yoko Wakatsuki and Junko Ogura), one of the more alarming reports from the week: “More people from the quarantined Diamond Princess cruise ship tested positive for the novel coronavirus Wednesday, according to the Japanese Health Ministry. The ministry said 79 new cases were confirmed, adding that 68 of the people were said to be asymptomatic.”

For the US and China, interdependence is a double-edged sword

Economic exchange can produce welfare gains, but it can also be used as a weapon

Joseph Nye

China's President Xi Jinping (R) and US President Donald Trump attend a welcome ceremony at the Great Hall of the People in Beijing on November 9, 2017. / AFP PHOTO / FRED DUFOUR (Photo credit should read FRED DUFOUR/AFP via Getty Images)
Understanding power and interdependence in the US-China relationship depends on understanding America’s strategic objectives © AFP via Getty Images

With the coronavirus outbreak, nature has reminded us how much the US and China are economically entangled. But politics is also involved as some in Washington form strategies for a second cold war and economic decoupling.

Economic exchange can produce welfare gains for both sides, but it can also be used as a strategic weapon. The Trump administration’s National Security Strategy identifies China as a strategic threat. But what kind of threat is it, and how much entanglement can the US afford?

Understanding power and interdependence in the US-China relationship depends on understanding America’s strategic objectives. If its relationship with China is zero sum, and China’s long-term objective is to destroy the US much like Hitler’s Germany in the 1930s, then the less interdependence the better, though in the military and environmental domains some will be unavoidable.

However, by focusing solely on the manipulation of economic vulnerability as a weapon, strategists can ignore that fact that interdependence can also have the positive effect of stabilising deterrence. Punishment and denial are central to the classical conception of deterrence, but they are not the only components of dissuasion. Entanglement is another important means of making an actor see that the costs of an action will sometimes exceed the benefits, hurting the attacker as well as the target.

For example, in 2009 the People’s Liberation Army urged the Chinese government to sell some of China’s massive holdings of dollars to punish the US for selling arms to Taiwan. The People’s Bank of China pointed out, however, that doing so would impose large costs on China. The government sided with the central bank. Dumping dollars might bring the US to its knees, but it would also have devastating consequences for China.

Similarly, in current scenarios that envisage a Chinese cyber attack on the US power grid, the two countries’ economic interdependence would mean costly damage to China as well. Precision attacks on minor economic targets might not produce much direct blowback, but the rising importance of the internet to economic growth increases general incentives for self-restraint. The legitimacy of the Chinese Communist party depends heavily upon economic growth, and economic growth in China increasingly depends upon the internet.

Critics of crude claims that economic interdependence guarantees peace, point to the first world war as evidence that such ties did not prevent a catastrophic conflict between major trading partners. That is true, but it goes too far in dismissing outright the possibility that interdependence can reduce the probability of conflict. The author Norman Angell and others were wrong to argue before 1914 that economic interdependence had made war impossible. But they were not wrong that it had greatly increased war’s cost.

Of course, conflict is always possible because of human miscalculation. Most European leaders in 1914 incorrectly envisaged a short war with limited costs. And trade between the US and Japan did not prevent the Japanese attack on Pearl Harbor; although that was partly caused by the American embargo on exports to Japan. The embargo manipulated economic interdependence in a way that led the Japanese to fear that failure to launch a risky attack would lead to their strangulation.

Entanglement is sometimes called “self-deterrence”, but that term should not lead analysts to dismiss its importance. The belief that costs will exceed benefits may be accurate, and self-restraint may result from rational calculations of interest. But we should remember that the perceptions of the target, though crucial, are not the only perceptions that matter in deterrence.

It should also be a reminder that an international deterrent relationship is a complex set of repeated interactions between complex organisations that are not always unitary actors. Moreover, these actors can adjust their perceptions in varying ways. The economic relationship between the US and China is a good example of this.

As the political scientist Robert Axelrod has shown, repeated relationships can nurture co-operative restraint and reciprocity. In addition, some interdependence, in which a state has a general interest in not upsetting the status quo, is systemic.

It does not follow from this that we should ignore the strategic costs of interdependence. And we should expect some decoupling of the US from China in sensitive high-tech areas that affect national security. Excluding companies such as Huawei from western 5G telecommunications networks is not very different from China’s exclusion of Google or Facebook for the past decade.

But we should not let misplaced fears lead to comprehensive decoupling. Interdependence is a double-edged sword, of course, but carefully wielded it can also contribute to deterrence and strategic stability.

The writer is a professor at Harvard and author of ‘Do Morals Matter? Presidents and Foreign Policy from FDR to Trump’

Fantasy Fiscal Policy

Many leading central bankers now argue that, instead of just playing its traditional role of deciding the allocation of government spending, investment, taxes, and transfers, fiscal policy must substitute for monetary policy in economic fine-tuning and fighting recession. That would be a big mistake.

Kenneth Rogoff

rogoff190_NikadaGetty Images_stockmarketdigitalpeople

LONDON – Will the next recession be worse than you think? With the major central banks having little space for further interest-rate cuts, might the next cyclical downturn become a crash?

In theory, fiscal policy can go far in filling the void.

The past decade has seen a rise in fiscal evangelism among many economists and policymakers, and it is indeed likely that fiscal fine-tuning will be widely tested in the next downturn.

Are they right?

I am skeptical. Fiscal policy is far too politicized to substitute consistently for modern independent technocratic central banks, which until now have largely taken the lead in short-term stabilization.

Fiscal policy takes the lead in fundamental but hugely contentious issues – concerning growth, long-term stability, and allocation – that need to be decided in a democratic fashion, at least in advanced economies.

And yet academic depictions of fiscal policy as an objective technocratic tool often make one feel like we are living in an episode of the American television series The West Wing.

In that critically acclaimed series, the fictional Democratic US president, Jed Bartlet, is an economist by training. A good and moral person, supported by similarly well-intentioned and brilliant staff, Bartlet exhibits a gift for weighing sophisticated advice from experts to reach nuanced economic-policy decisions that strike a balance between efficiency, fairness, and political realities.

Of course, he often faces opposition in getting his legislation passed, but Bartlet and his staff generally prevail. It does not hurt that the ideologues on the right who oppose Bartlet are not only bad people, but also intellectual lightweights.

It is not just academic economists who are arguing that the time has come for activist fiscal policy, given the limits to monetary policy in an environment of ultra-low interest rates. Many leading central bankers also maintain that, instead of just playing its traditional role of deciding the allocation of government spending, investment, taxes, and transfers, fiscal policy can substitute for monetary policy in economic fine-tuning and fighting recession.

Touring the economic journals and major meetings of academic economists, one sees model after model of West Wing fiscal policy – thoughtful, reliable, and credible – that seems to buttress such arguments. But the recent literature and debate almost completely ignores political-economy issues that were studied intensively in the 1980s and 1990s. The lessons learned then are now largely forgotten.

It is precisely because fiscal policy inevitably involves messy, hard-fought compromises – often overturned by future elections anyway – that most countries have turned to central banks for short-term stabilization policy. The modern, independent, technocratic central bank is arguably the greatest innovation in macroeconomics since John Maynard Keynes pioneered demand management.

Governments can and should make the big decisions about the long-term direction of policy, but anyone who thinks that legislatures can consistently make fine-tuned decisions is living in an alternative reality.

The fact is that in most countries today, economic policy is highly polarized, with decisions being made by razor-thin majorities. In the United States, for example, fiscal policy for Democrats largely means an opportunity to engage in more spending and transfers. For Republicans, it means cutting taxes in order to downsize government.

Such differences are a recipe for seesaw policy. As a short-run stabilization tool, fiscal policy will inevitably be difficult to time and calibrate in the same way that central banks have succeeded in doing with monetary policy.

Especially over the past 20 years, central bankers have increasingly recognized that consistent, stable, and predictable policies are just as important as any short-term decision-making. Indeed, at conference after conference, central bankers can be heard weighing the nuances of slight changes in messaging and their effects on expectations.

But in West Wing-style academic papers, fiscal-policy functions – government spending and tax policy – are assumed to be totally stable and predictable. All problems concerning credibility and consistency are assumed away.

It is possible that in the next recession, fiscal policy in some countries will land a lucky punch, getting the calibration and timing just right. And yes, central bankers sometimes get it wrong.

But the idea that we should cast aside the division of assignments between the two is naive. So is the idea that strengthening “automatic stabilizers” such as unemployment insurance and transfers can solve all problems of fiscal-policy credibility by enabling adjustment to occur without political action.

The fact is that stabilizers invariably have incentive effects, and political battles over how far any should be expanded are inevitable. But the deeper problem is that in any given circumstance, policymakers can – and often do – override automatic stabilizers.

The right solution is not to cast aside monetary policy, but to find ways to strengthen its effectiveness in a low-interest-rate environment, possibly by finding ways to use negative rates more fairly and effectively.

Until then, with monetary policy hampered and fiscal policy the main game in town, we should expect more volatile business cycles.

Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University and recipient of the 2011 Deutsche Bank Prize in Financial Economics, was the chief economist of the International Monetary Fund from 2001 to 2003. He is co-author of This Time is Different: Eight Centuries of Financial Folly and author of The Curse of Cash.

MacroView: Japan, The Fed, And The Limits Of QE

by: Lance Roberts


- The Fed recognizes their ongoing monetary interventions have created financial risks in terms of asset bubbles across multiple asset classes.

- Since the financial crisis, Japan has been running a massive "quantitative easing" program which, on a relative basis, is more than 3-times the size of that in the U.S.

- It has taken a massive amount of interventions by central banks to keep economies afloat globally over the last decade, and there is rising evidence that growth is beginning to decelerate.

- Furthermore, we have much more akin with Japan than many would like to believe.
This past week saw a couple of interesting developments.
On Wednesday, the Fed released the minutes from their January meeting with comments which largely bypassed overly bullish investors.
"… several participants observed that equity, corporate debt, and CRE valuations were elevated and drew attention to high levels of corporate indebtedness and weak underwriting standards in leveraged loan markets. Some participants expressed the concern that financial imbalances-including overvaluation and excessive indebtedness-could amplify an adverse shock to the economy …" 
"… many participants remarked that the Committee should not rule out the possibility of adjusting the stance of monetary policy to mitigate financial stability risks, particularly when those risks have important implications for the economic outlook and when macroprudential tools had been or were likely to be ineffective at mitigating those risks…"
The Fed recognizes their ongoing monetary interventions have created financial risks in terms of asset bubbles across multiple asset classes. They are also aware that the majority of the policy tools are likely ineffective at mitigating financial risks in the future. This leaves them being dependent on expanding their balance sheet as their primary weapon.
Interestingly, the weapon they are dependent on may not be as effective as they hope.
This past week, Japan reported a very sharp drop in economic growth in their latest reported quarter as a further increase in the sales-tax hit consumption. While the decline was quickly dismissed by the markets, this was a pre-coronovirus impact, which suggests that Japan will enter into an "official" recession in the next quarter.
There is more to this story.
Since the financial crisis, Japan has been running a massive "quantitative easing" program which, on a relative basis, is more than 3-times the size of that in the U.S.
However, while stock markets have performed well with central bank interventions, economic prosperity is only slightly higher than it was prior to the turn of century.
Furthermore, despite the BOJ's balance sheet consuming 80% of the ETF markets, not to mention a sizable chunk of the corporate and government debt market, Japan has been plagued by rolling recessions, low inflation, and low-interest rates. (Japan's 10-year Treasury rate fell into negative territory for the second time in recent years.)
Why is this important?
Because Japan is a microcosm of what is happening in the U.S.

"The U.S., like Japan, is caught in an ongoing 'liquidity trap' where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the battle with deflationary pressures. The lower interest rates go - the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments, and risk begins to outweigh the potential return. 
Most importantly, while there are many calling for an end of the 'Great Bond Bull Market,' this is unlikely the case. As shown in the chart below, interest rates are relative globally. Rates can't increase in one country while a majority of economies are pushing negative rates. As has been the case over the last 30 years, so goes Japan, so goes the U.S."
As my colleague Doug Kass recently noted, Japan is a template of the fragility of global economic growth.

"Global growth continues to slow and the negative impact on demand and the broad supply interruptions will likely expose the weakness of the foundation and trajectory of worldwide economic growth. This is particularly dangerous as the monetary ammunition has basically been used up. 
As we have observed, monetary growth (and QE) can mechanically elevate and inflate the equity markets. For example, now in the U.S. market, basic theory is that in practice a side effect is that via the 'repo' market it is turned into leveraged trades into the equity markets. But, again, authorities are running out of bullets and have begun to question the efficacy of monetary largess. 
Bigger picture takeaway is beyond the fact that financial engineering does not help an economy, it probably hurts it. If it helped, after mega-doses of the stuff in every imaginable form, the Japanese economy would be humming. But the Japanese economy is doing the opposite. Japan tried to substitute monetary policy for sound fiscal and economic policy. And the result is terrible. 
While financial engineering clearly props up asset prices, I think Japan is a very good example that financial engineering not only does nothing for an economy over the medium to longer-term, it actually has negative consequences."
This is a key point.

The "Stock Market" Is NOT The "Economy"
Roughly 90% of the population gets little, or no, direct benefit from the rise in stock market prices.
Another way to view this issue is by looking at household net worth growth between the top 10% to everyone else.
Since 2007, the ONLY group that has seen an increase in net worth is the top 10% of the population.

"This is not economic prosperity.
This is a distortion of economics."
From 2009-2016, the Federal Reserve held rates at 0%, and flooded the financial system with 3 consecutive rounds of "Quantitative Easing" or "Q.E." During that period, average real rates of economic growth rates never rose much above 2%.
Yes, asset prices surged as liquidity flooded the markets, but as noted above, "Q.E." programs did not translate into economic activity.
The two 4-panel charts below shows the entirety of the Fed's balance sheet expansion program (as a percentage) and its relative impact on various parts of the real economy. (The orange bar shows now many dollars of increase in the Fed's balance sheet that it took to create an increase in each data point.)

As you can see, it took trillions in "QE" programs, not to mention trillions in a variety of other bailout programs, to create a relatively minimal increase in economic data.
Of course, this explains the growing wealth gap, which currently exists as monetary policy lifted asset prices.
The table above shows that QE1 came immediately following the financial crisis and had an effective ratio of about 1.6:1.
In other words, it took a 1.6% increase in the balance sheet to create a 1% advance in the S&P 500. However, once market participants figured out the transmission system,
QE2 and QE3 had an almost perfect 1:1 ratio of effectiveness.
The ECB's QE program, which was implemented in 2015 to support concerns of an unruly "Brexit," had an effective ratio of 1.5:1.
Not surprisingly, the latest round of QE, which rang "Pavlov's bell," has moved back to a near perfect 1:1 ratio.
Clearly, QE worked well in lifting asset prices, but as shown above, not so much for the economy.
In other words, QE was ultimately a massive "wealth transfer" from the middle class to the rich which has created one of the greatest wealth gaps in the history of the U.S., not to mention an asset bubble of historic proportions.
But Will It Work Next Time?
This is the single most important question for investors.
The current belief is that QE will be implemented at the first hint of a more protracted downturn in the market. However, as suggested by the Fed, QE will likely only be employed when rate reductions aren't enough. This was a point made in 2016 by David Reifschneider, deputy director of the division of research and statistics for the Federal Reserve Board in Washington, D.C., released a staff working paper entitled, "Gauging The Ability Of The FOMC To Respond To Future Recessions."
The conclusion was simply this:
"Simulations of the FRB/US model of a severe recession suggest that large-scale asset purchases and forward guidance about the future path of the federal funds rate should be able to provide enough additional accommodation to fully compensate for a more limited [ability] to cut short-term interest rates in most, but probably not all, circumstances."
In other words, the Federal Reserve is rapidly becoming aware they have become caught in a liquidity trap, keeping them unable to raise interest rates sufficiently to reload that particular policy tool. There are certainly growing indications the U.S. economy may be heading towards the next recession.
Interestingly, David compared three policy approaches to offset the next recession.
  1. Fed funds goes into negative territory but there is no breakdown in the structure of economic relationships.
  2. Fed funds returns to zero and keeps it there long enough for unemployment to return to baseline.
  3. Fed funds returns to zero and the FOMC augments it with additional $2-4 Trillion of QE and forward guidance.
In other words, the Fed is already factoring in a scenario in which a shock to the economy leads to additional QE of either $2 trillion, or in a worst case scenario, $4 trillion, effectively doubling the current size of the Fed's balance sheet.
So, 2 years ago David lays out the plan, and on Wednesday, the Fed reiterates that plan.
Does the Fed see a recession on the horizon? Is this why there are concerns about valuations?

But there is a problem with the entire analysis. The effectiveness of QE, and zero interest rates, is based on the point at which you apply these measures.
In 2008, when the Fed launched into their "accommodative policy" emergency strategy to bail out the financial markets, the Fed's balance sheet was running at $915 billion. The Fed Funds rate was at 4.2%.
If the market fell into a recession tomorrow, the Fed would be starting with a $4.2 trillion balance sheet with interest rates 3% lower than they were in 2009.
In other words, the ability of the Fed to 'bail out' the markets today is much more limited than it was in 2008.
But there is more to the story than just the Fed's balance sheet and funds rate. The entire backdrop is completely reversed. The table below compares a variety of financial and economic factors from 2009 to present.
Importantly, QE, and rate reductions, have the MOST effect when the economy, markets, and investors are extremely negative.
In other words, there is nowhere to go but up.
Such was the case in 2009. Not today.
This suggests that the Fed's ability to stem the decline of the next recession, or offset a financial shock to the economy from falling asset prices, may be much more limited than the Fed, and most investors, currently believe.
It has taken a massive amount of interventions by central banks to keep economies afloat globally over the last decade, and there is rising evidence that growth is beginning to decelerate.

Furthermore, we have much more akin with Japan than many would like to believe.
  • A decline in savings rates
  • An aging demographic
  • A heavily indebted economy
  • A decline in exports
  • Slowing domestic economic growth rates
  • An underemployed younger demographic
  • An inelastic supply-demand curve
  • Weak industrial production
  • Dependence on productivity increases
The lynchpin to Japan, and the U.S., remains demographics and interest rates. As the aging population grows, becoming a net drag on "savings," the dependency on the "social welfare net" will continue to expand. The "pension problem" is only the tip of the iceberg.
While another $2-4 trillion in QE might indeed be successful in keeping the bubble inflated for a while longer, there is a limit to the ability to continue pulling forward future consumption to stimulate economic activity. In other words, there are only so many autos, houses, etc., which can be purchased within a given cycle. There is evidence the cycle peak has been reached.
If the effectiveness of rate reductions and QE are diminished due to the reasons detailed herein, the subsequent destruction to the "wealth effect" will be larger than currently imagined. The Fed's biggest fear is finding themselves powerless to offset the negative impacts of the next recession.
If more "QE" works, great.
But as investors, with our retirement savings at risk, what if it doesn't.

BlackRock trims 30-year Treasuries after rally

Exclusive: Fixed income chief says long-dated bond yields ‘not anywhere close’ to correct

Colby Smith in New York

Rick Rieder for FTFM
BlackRock's Rick Rieder: 'With bad news, everyone goes one way. You want to try to be on the other side of it' ©

BlackRock, the world’s biggest asset manager, on Friday sold some of its holdings of 30-year US Treasury bonds, after concluding that current low yields were “not anywhere close to fundamentally correct”.

Rick Rieder, BlackRock’s chief investment officer of global fixed income, who oversees the group’s $2.3tn bond portfolio, told the Financial Times that it pared down its exposure to long-dated US Treasuries as the yield fell below 1.9 per cent for the first time ever.

Intensifying concern over the spread of coronavirus outside China sent investors rushing to safe assets on Friday, while weak data on the US economy further stoked the rally in Treasuries.

“[Rates] at these levels are not anywhere close to fundamentally correct,” Mr Rieder told the FT. “With bad news, everyone goes one way. You want to try to be on the other side of it.”

The 30-year Treasury yield has fallen 47 basis points since the start of the year, while the yield on the benchmark 10-year bond has slipped by a similar amount, to below 1.5 per cent.

Yields on longer-dated debt have fallen faster than those on shorter-dated notes, prompting an inversion of the yield curve that investors fear is a signal of impending recession.

Mr Rieder did not predict a dramatic reversal, however, and described BlackRock’s actions as “taking chips off the table” rather than a more dramatic exit from long-term Treasuries.

“Markets can stay fundamentally impure for much longer than people think,” he cautioned.

Line chart of Yield (%) showing US 30-year Treasury yield falls to record low

The Treasury market rally has intensified as signs of the economic fallout from the coronavirus has grown in recent weeks. The virus has claimed more than 2,200 lives, infected over 76,000 and disrupted supply chains across the world.}

Expectations for US monetary policy have shifted as a result, and markets are pricing in at least one quarter-point reduction in US interest rates in the second half of the year, according to futures prices compiled by Bloomberg.

Mr Rieder said he did not agree, since most economic data out of the US remains solid, and the Federal Reserve has signalled its intention to keep rates at current levels throughout 2020. “The Fed wants to stay on hold and see where things go,” he said.

The global fixed income business overseen by Mr Rieder accounts for $2.3tn of BlackRock’s $7.4tn in assets under management.

The largest single fund managed by Mr Rieder, the $35bn BlackRock Strategic Income Opportunities, has returned 1.6 per cent so far this year, outpacing its peers by 0.9 per cent, according to Morningstar.