Volatility – Part 2
For this week, we had more of the same situation in the financial market: biggest stock indices crashing and bouncing back the next day and central banks exhausting their few monetary tools left.
Nevertheless, there is a new player in the game: expansionary fiscal policy, mainly in the form of increased government spending but also, in some cases, with delayed or temporarily suspended tax payments. For instance, the latest $1.2 trillion stimulus in the US, US income tax payment delayed 90 days or the $350 billion additional spending in the UK.
To start, I would like to write about a crucial but undervalued monetary tool the Fed announced on Sunday, in addition to the 100 bp further cut in the base interest rate:
Dollar Swap Lines
When it comes to international trade, the US Dollar (USD) is the main, by far, means of exchange.
From the moment a huge economic shock happens, in this case, the Coronavirus emergency, most of the business all over the world experience tough cash-flow difficulties.
Most of the European countries are in a complete lockdown. As a consequence, their revenues fall sharply but they still have to face fixed costs. Many businesses default in their payments and companies’ stock of USD drop.
What companies do when they don’t have enough liquidity to face their payments?
Ask for financing.
However, is the non-US financial system capable to satisfy the demand for USD?
Not really. In the financial market, after these two weeks, there has been a cash crunch. Assets have been liquidated really sharply, e.g the S&P500 has wiped out all its 2019 growth, drawing upon available cash. This leads to an uneven distribution of USD between non-US private banks.
Many of the banks will have funding shortages. And their own central banks cannot flood them with cheap dollar-denominated liquidity. The latest ECB USD auction charged 1.24% fixed rate. Furthermore, a big chunk of trade is through non-banks which cannot access to central bank funding. Hence dollar swap lines.
The improved conditions will make this swap line more appealing than those that existed in 2008. The funding lasts for 84 days and only an interest rate 25 bp above the OIS rate (Overnight Indexed Swap rate) is applied. The OIS rate regulates the interest rate applicable on risk-free overnight loans.
Nevertheless, I would stress this is not a complete solution. There is not any dollar swap lines with the PBoC (People’s Bank of China) even though it is the most important central bank in relation to trade.
As said by Credit Suisse Zoltan Pozsar on March 3rd:
“Once the PBoC exhausts its dollar liquidity in cash markets like the FX swap market, it will next tap its Treasury portfolio and will either repo or sell those Treasuries through dealers in New York to raise more dollars to lend to local banks”.
And what happens with the Quantitative Easing (QE) impact the Fed has implemented again?
It is reduced significantly. The Fed buys Treasuries (US government bonds) and other type of securities to flood with money the system, promote investment and increase output while the PBoC sells Treasuries and other USD-denominated assets to lend to their national companies. The Fed $700 bn QE program economic effects are less noticeable as a result.
Finally, I will describe the current situation of one of the most punished markets in this economic recession:
How has the price dropped that sharply in a matter of two weeks?
The initial cause was the 20% reduction in oil demand in the biggest oil importer in the world, China. Western Europe and the US followed suit with the current lockdown situations in these areas. Then, a disagreement between Russia and Saudi Arabia with supply cuts did the rest. Despite Russia’s budget on deficit with current prices, Putin holds out and doesn’t submit to Saudi Arabia price war.
What is the reason, then, behind Friday’s spike in oil prices?
Trump has come to the rescue of US independent and small shale producers, promising to buy 30 million barrels amid oil crisis initially. They are to be delivered in May-June to fill up the Strategic Reserves usually used in times of war, natural disasters, high oil prices…
The U.S Energy department plans to buy 77 million barrels in total to fill up the reserve. Furthermore, Congress could be asked to approve a $20 billion allocation to keep the reserve full for a decade to estimulate the oil market. As a result, investors responded today with an extended gain from $20 up to $26.7- 27.5 at the time of writing the blog.
Here it is the chart:
As always, I leave here the S&P500 map 1-week performance, very useful to get a global view of the market evolution:
Disclaimer: Do not take any of the opinions shared here as Investment advice. Whenever you want to start investing make sure you do your own research and seek professional advice for any investment decisions you make in the future. Hope you enjoyed the read!