FX Week - 8th March 2020

The last fortnight has seen markets abruptly catch up with the reality of the coronavirus crisis.

By Emirates NBD Research

The last fortnight has seen markets abruptly catch up with the reality of the coronavirus crisis, with bond and equity markets in particular forcing the Fed’s hand to cut interest rates by 50bps last week, for the first inter-meeting change in rates since the 2008 financial crisis, and taking the lower bound of the Fed funds rate to 1.0%. This was very much a preemptive step to guard against an economic slowdown, with demand now becoming just as negatively affected by the global impact of coronavirus as supply.

The Fed Chair Jerome Powell said that the central bank took action after officials saw that the coronavirus outbreak was having a material impact on the economic outlook. While the G7 held a conference call to coordinate its responses and the Fed said it was ready to act further, not much coordination appeared to be in evidence with only limited monetary policy responses elsewhere, as well as some fiscal support from the IMF and World Bank.

The Reserve Bank of Australia and the Bank of Canada were the only other prominent central banks to make similar moves to the Fed and the markets are awaiting decisions from the Bank of England the European Central Bank (ECB) in coming weeks. It was quickly apparent, however, that markets were not satisfied with the Fed’s move as equity markets and bond yields continued to fall, with the 10-year yield hitting an historic intraday low of 0.657%. Expectations are that the Fed will cut interest rates again at their next meeting on the 17-18th March, with more after that, which is undermining the USD on all fronts. The CHF, JPY and the EUR were the main beneficiaries, all strengthening in excess of 2.0% against the U.S. currency. However, even such rate cuts are not guaranteed to reverse negative sentiment given the overwhelming sense of unease, with markets continuing to take their cue from medical developments rather than economic ones.

Such interest rate cuts would also leave the Fed dangerously exposed should the economic situation begin to really deteriorate, as it would leave the lower bound of US interest rates close to zero. Although the U.S. jobs data held up strongly in February with 273k new jobs created, the closer the Fed gets to the zero bound, concerns will legitimately grow about the ability of the Fed to respond to further shocks. It will also cast doubt on its ability to escape from the scourge of zero interest rates further down the road, given the experience of the ECB and the Bank of Japan in this regard over recent years.