Coronavirus update: implications for U.S. interest rates

 

Fears that the coronavirus outbreak could spread further have sent a chill through the financial markets. While it’ll be some time before the true economic cost of the outbreak becomes clear, Frances Donald identifies five reasons why events in the last two weeks could convince the U.S. Federal Reserve (Fed) to cut rates soon.

 
Coronavirus update: implications for U.S. interest rates

More than likely, the violent swings that we witnessed in the financial markets this past week will end up in an economic textbook in the near future. It’ll probably also include a critique of policy actions taken by policymakers in an effort to contain the economic fallout brought about by the outbreak.

And if we’re right, it’ll include a swift(ish) response from the U.S. Federal Reserve (Fed). At this point, financial markets have priced in a full 25 basis points rate cut from the Fed by June.1 This is consistent with our views, which we’ve held for the past six months. Critically, we believe the Fed could act at its next meeting on March 18, and that the likelihood of more than one rate cut by June is quickly rising.

Here are five reasons why we believe the Fed could act soon.

1 Global economic data is weak and will continue to be weak

In view of recent developments, access to traditional economic data remains challenging but high-frequency indicators available so far suggest China may have actually contracted in the first quarter. Crucially, production shutdowns that have taken place as a result of the outbreak will have important implications for global supply chains.

From a growth perspective, we believe a “consumer confidence and spending” shock would represent the most problematic aspect of the escalation in the coronavirus outbreak. While it’s true that the U.S. economy may be more insulated to these developments than most, it isn’t immune to supply or demand shocks. It’s also worth noting that unlike supply-side shocks, demand-side shocks aren’t always recouped (i.e., if you didn’t buy a latte one day, you don’t necessarily buy two the next day).

Specifically, the global economy is dealing with the outbreak not from a place of strength but from a place of weakness. We believe this could play a part in shaping the Fed’s thinking when it next meets in March. 

2 The deflationary impulse cometh

Undoubtedly, the inflation picture for 2020 looks worse now than it did at the start of the year. In fact, market developments in the last two months have, in our view, strengthened the case for further monetary easing. The greenback has strengthened consistently since January: a stronger U.S. dollar (USD) has a mechanically deflationary impact on inflation. Most importantly, market-based inflation expectations, an important indicator that informs the Fed’s inflation outlook, have plummeted. ¹

Meanwhile, the commodities complex—with the exception of gold—has slipped into correction mode.1 This will translate into lower input costs for businesses over time, creating another source of deflationary pressure. Let’s also not forget that a stronger USD means increased buying power and another means of importing price pressures.

Bear in mind that before all this began, we were already looking at a Fed that’s attempting to engineer an inflationary overshoot and a more “symmetric” inflation target. In other words, at this point, there are even more reasons for the Fed to act. 

3 The yield curve is inverting … again

Arguably, an inverted yield curve represents a funding problem for businesses since it means that banks have less incentive to finance longer-term loans. But it's also an issue that could have important implications for growth if the Fed doesn't cut rates soon and bring the front-end curve down. We could be looking at a disorderly rally in the USD, a tigthening of financial conditions, and a further equity sell-off (as a result of the first two factors)—none of which is constructive to growth.

4 A strong U.S. dollar could be problematic

It's fair to say the U.S. economy has more or less decoupled from rest of the world (from a growth perspective) and by extension, it’s likely to be the most resilient to the fallout triggered by the spread of the coronavirus. After all, housing remains strong and the U.S. consumer is still spending. This strength, however, combined with the USD’s safe-haven status, could weigh on U.S. manufacturing activity and tighten global financial conditions. Did we already mention that a strong USD is mechanically deflationary?

5 Weakness in Q1 economic data could create an opportunity to lower rates

We've always said that Q1 will be a pain point for U.S. growth. Halfway into the quarter and we've identified a few issues that could lead to economic disappointment in the coming months.

Last week's weaker-than-expected services Purchasing Managers' Index, which is closely followed by the Fed, is one of them. The index slipped into "contraction" territoriy in February, with survey participants noting their concerns about a possible broader economic slowdown and heightened uncertainty ahead of November's U.S. presidential election.²

Separately, it's worth remembering that Boeing 737 MAX production shutdowns, which may only resume in June, are widely expected to weigh on growth. That's also likely to have an impact on hiring, and in our view, there's a reasonable likelihood that the U.S. jobs market could cool slightly in the March/April timeframe.

Under normal circumstances, these data points would not be sufficient to nudge the Fed into cutting rates. But at this point, we're inclined to believe that these pockets of weakness will provide the Fed with the cover it needs to potentially introduce "insurance cuts."

Finally, the upcoming election could also convince the Fed to act sooner rather than later. While it'll never admit that it's at all swayed by politics, the timing of the election could, at the margin, encourage the central bank to cut rates sooner than it might have otherwise.

What happens next?

At this juncture, it's difficult to tell when the selling pressure in the financial markets will ease. We continue to believe that an economic recovery will take hold in the second half of the year.

In time to come, it's possible that economic students will one day look back on the coronavirus outbreak and view it as a market event that has helped to shed some light on the effectiveness as well as the limits of monetary policy.  

1 Bloomberg, as of 2/26/20. 2 IHS Markit, 2/21/20.