Coronavirus: The end of monetary dominance is here

March 18 2020

Jim McCormickGlobal Head of Desk Strategy

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It’s been a dramatic couple of weeks as the coronavirus crisis has rapidly travelled outside of China. The spotlight has well and truly shifted towards the support measures that governments can provide, not just global central banks. But what does it really mean to see the end of monetary policy dominance?

Market volatility at its highest level since 2008

The past two weeks have by far been the most dramatic in the two-month long coronavirus crisis.  And by some market measures, possibly the most dramatic two weeks in decades. Perhaps most notably, cross asset implied volatility reached its highest level since the 2008 Global Financial Crisis (GFC). Even during the GFC, the build-up in implied volatility happened over the course of more than a year – the index bottomed in May 2007 and was on its way back down just before the Lehman bankruptcy in September 2008 (Chart 1).

Signs of dysfunction in financial markets were everywhere, and in response, we have seen announcement after announcement from central bankers – there have been so many it’s been hard to keep track. What we can say for certain is that the end of monetary dominance is here. Because for the first time in long time, fiscal measures from governments all across the globe have also been announced.

Chart 1: NatWest Markets Core++ Macro Implied Volatility Index

Source: NatWest Markets, Bloomberg 

What does the end of monetary dominance mean?

The end of monetary dominance doesn’t mean to say that it’s the end of monetary policy – not at all; in fact central banks have clearly stated that their policy will remain loose for some time. What we mean is that monetary policy is no longer enough, and the need for fiscal action from governments on the economy is well and truly upon us. This means government spending – big government spending – is back. What we know now is that governments will not hold back. They will spend whatever it takes and will do more if necessary. This big spending will also include spending in the euro area, to this day we still see scepticism in the Euro Area, our view is they have already promised a lot, and will promise more if necessary. 

Banks are becoming a part of the solution

An interesting theme that has been evolving is that policymakers are increasingly focused on making banks part of the solution. In Europe especially, where banks have been under severe pressure as a result of easy monetary policy and strict regulatory requirements, recent announcements have been encouraging. It is hard to say whether this will provide enough cover for banks, but it is clear European policymakers increasingly recognise the strains the banking sector is incurring. This is a big change. 

What are the implications for markets?

As we said in our 2020 Year Ahead, more reliance on fiscal policy and less on monetary stimulus could have significant implications for markets. Most notably it should mean higher bond yields (all else equal) and higher risk premia - both were on display in the past two weeks. Despite the market shock, G10 bond yields look on course to end the week higher! Consistent with this, the rolling correlation between equity and fixed income returns has spiked (Chart 2). If it continued, it would be the strongest evidence yet that financial markets can’t rely on central banks to anywhere near the degree they have in the past decade.

Chart 2:  Correlation between US equity & fixed income returns

Source: NatWest Markets, Bloomberg

Policies are secondary

It is hard to know when markets will settle, as we have yet to even see the actual growth impact outside of China from the coronavirus crisis. Ultimately, we believe that the responses from global policy makers will matter for markets, perhaps currencies especially. But in today’s dysfunctional conditions, fundamentals and policies are secondary.

Fiscal policy
Central banks

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