• Coronavirus fears paralyzed risk markets in the final week of February
  • Markets are now pricing for Fed rate cuts in March and April and an emergency rate cut of 50 bps was announced on March 3
  • Fed Chair Powell issued a short statement on February 28 saying that the Fed will “act as appropriate to support the economy”
  • February PMI data was much weaker than expected, and the combination of tighter financial conditions and a tepid January PCE inflation report may give the Fed the cover it needs to ease policy

Coronavirus (COVID-19) fears overwhelmed global financial markets in late February, sending equity indices sharply lower and the 10-year Treasury yield to record lows. Initial concerns were more focused on supply chain disruptions in China, but as reports surfaced of new cases being reported in Europe, Brazil, and other Asian countries, the tone in equity markets shifted more bearish and more in line with what was already present in fixed-income markets for much of 2020.  As discussed in last month’s commentary, financial markets have been speculating on the ultimate impact on the global economy from the viral outbreak, and the more recent “panic” is based on worries that a global pandemic is emerging that will have a greater and more prolonged impact on global growth than initially anticipated. To this point, World Health Organization (WHO) officials have not labeled this as a “pandemic.”  At the end of the day, it’s difficult to forecast something so fluid as this, and in the meantime, uncertainty fuels volatility and risk-off sentiment.

Prior to the late February risk-off trade, the general expectation has been that there would be a V-shaped recovery in the global economy, with the greatest economic whipsaw experienced in China. In other words, a contraction in economic output would only be limited to one quarter before rebounding sharply in the following quarters, which was essentially what was experienced during the 2002/2003 SARS outbreak. This expectation had been voiced by Fed and ECB leaders as well, but markets have obviously become less confident in that assessment. Exhibit 1 illustrates the recent change in market expectations for future rate policy by the Fed using pricing in the fed funds futures market. At the end of 2019, a full 25 bps rate cut was not priced for all of 2020. By the middle of February, the market was pricing a full cut at the September meeting and effectively 1.5 rate cuts for the entire year. However, with last week’s turmoil, market pricing now implies a rate cut at the March FOMC meeting and nearly 100 bps of rate cuts by the end of the year. Additionally, 3-month LIBOR declined by 12 bps on February 28, the largest daily decline since December 2008. On March 3, the Fed initiated an emergency rate cut, which hadn’t happened since the financial crisis.

There’s an old saying in the markets that “the prices have changed more than the facts,” and as such, the Fed had been careful to stay relatively quiet with regard to any potential monetary policy response to the coronavirus worries. Fed Vice Chair Richard Clarida spoke on February 25 and effectively said that it is still too soon to say whether the coronavirus materially changes the U.S. economic outlook. On February 28, St. Louis Fed President James Bullard said he would be supportive of rate cuts if coronavirus evolves into a global pandemic, but at the same time, he said last year’s rate cuts are already supporting the U.S. economy. However, the market is now putting a lot of pressure on the central bank to respond, and it will be difficult for the Fed to resist these forces without a swift and sharp reversal in market sentiment. To this end, Fed Chair Jerome Powell released the following simple, three-sentence statement on the afternoon of February 28:

The fundamentals of the U.S. economy remain strong. However, the coronavirus poses evolving risks to economic activity. The Federal Reserve is closely monitoring developments and their implications for the economic outlook. We will use our tools and act as appropriate to support the economy.

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