Covid-19 Central Bank Policy Response

Friday 20th March 2020

Covid-19 Central Bank Policy Response

Friday 20th March 2020
Written by Chris Lioutas

Some of you may have seen or heard of the recent policy action from central banks around the world in response to the significant economic and market impact caused by the response to control the spread of the virus.

The central bank response is one of the biggest stimulus packages we’ve ever seen and the right response in these trying times. Unfortunately the response came about 2 weeks too late, with central bankers failing to heed warnings and learn from the mistakes made in the past in terms of acting too late. I can’t help but be astonished and just plain angry at their delayed response – ie. a lot of the extreme market events we’ve seen in the last 2 weeks could’ve been lessened or softened if they had acted ahead of time.

The delayed response, whilst now showing signs of assisting markets in functioning more appropriately, will most probably mean they will need to provide even more stimulus at some stage over the next few weeks. The recent response, if levied 2 weeks ago, might have been sufficient.

In addition, governments have been too slow to provide fiscal stimulus. Those that have provided stimulus, ie. the Australian government, have effectively given a Tic Tac to a cancer patient as treatment. Whilst the amount of stimulus required is largely guesswork from here, those more informed are landing at a required amount of approximately 20-30% of GDP (economic growth). To put that in perspective, for the Australian government, that would mean a package of $380 billion to $570 billion of fiscal stimulus, whilst for the US government, it would mean a package of more than US $4 trillion! That number is unlikely at this stage with the most recent reports indicating US $1-1.2 trillion which would involve US $500bn in direct payments to US citizens.

Coming back to the central bank response, a lot of it is quite technical, but the main point of it is to:

  1. Prop up the banking system so that they can extend credit to businesses and households
  2. Provide a significant positive liquidity shock to global bond markets, which had effectively frozen over the last few days.
  3. Ensure bond yields remain extremely low in order to lower funding costs for banks and non-bank corporates.

Below is slightly longer detail, which I hope is a fairly easy-to-understand summation of the policy response we’ve seen to date:

RBA (Australia) 

  • Cut in the cash rate to 0.25% and almost a promise (technically called “forward guidance”) to keep rates at these levels for an “extended” period of time (read that as at least 2 years, if not longer). The cut was mostly psychological in that the big 4 banks can’t pass on the rate cut at these low levels.
  • Effectively “fixing” the 3 year Australian government bond yield at 0.25% by going into the market and buying/selling as much bonds as required to get the yield at that level – a form of quantitative easing or money printing.
  • Strengthening the banking system and providing support for credit to businesses, especially small to medium-sized businesses. Part of this involves fixing the 3 year bond rate at 0.25% which makes it significantly cheaper for the banks to lend money. The other part involves providing a line of credit at 0.25% interest to the banks to then on-lend to Australian businesses and households to support them through this time.
  • Ensuring the banks still earn interest on their deposits with the RBA, which would otherwise have fallen to 0% interest without their intervention.
  • Continuing to pump extra liquidity into the banking system via regular daily operations on an as per needed basis to ensure liquidity is maintained.

The Fed (US)

  • Cut their interest rate to 0% with forward guidance that it will remain at 0% long after the virus concerns begin to moderate
  • US$700 billion of money printing to step into the market and buy bonds (both government bonds and mortgage securities) to provide liquidity, with the buying likely to be front-ended (ie. buy a lot of bonds daily early on)
  • They stopped short of intervening in credit markets as that would’ve involved the US government, but they still may have to intervene at some point if the other measures aren’t enough to stabilise the bond markets, especially as it pertains to corporate borrowing costs.

ECB (Europe)

  • Spending 750 billion EUROs by stepping into markets and buying bonds in order to provide liquidity and encourage government bond yields to fall.
  • This is in addition to the very weak response from the ECB last week to buy just 120 billion EUROs.
  • The ECB didn’t cut their interest rate as it remains below 0%, ie. a negative rate.

Both central banks and governments now need to stand together and provide support – support to businesses, support to households, and support to investment markets. You can’t have “lock-down” with no support. We expect that support to be forthcoming.

As such, whilst we can’t yet say we’re through the worst of this from an investment market perspective, we do believe those support measures will mean we’re through the most of it.

Parting words as follows:

  1. Remain calm, don’t panic – panic involves irrational decision making and irrational decision making almost always results in a permanent loss of wealth.
  2. Whilst selling after large falls to protect additional falls might seem rational (ie. preventing further losses), it’s only really rational for those with short investment horizons less than 2 years. If your investment time horizon is longer than that, then our view is selling now is rather pointless unless you have a crystal ball.
  3. Whilst it might seem like we constantly bash governments and central banks, we largely do so regarding their poor communication skills and/or their delays in acting. However, they do always come through.

Don’t touch your face with your hands – the majority of virus transmission to date has been from hand to mouth, hand to nose, and hand to eyes contact. If you’re unwell, stay home, as should normally be the case. And please wash your hands before you handle food.

Author, Chris Lioutas, Director 

Insight Investment Consultants

Chris is an independent consultant and is a member of Maxim Private Clients Pty Ltd Investment Committee.

With permission of the author, this article is presented by Maxim Private Clients Pty Ltd AFSL No. 511972

Maxim Private Clients Pty Ltd ABN 47 611 614 398 AFSL No. 511972

Disclaimer: This material has been prepared without considering any potential investor's or clients objectives, financial situation or needs. This article is of a general nature and does not consider the individual circumstances of its recipients. Any information contained within this publication should not be misinterpreted as advice in any way. Please consult your financial advisor should you have any questions or concerns