Market Update: what’s going on?
The spread of the novel coronavirus (COVID-19) started in China in January and has been affecting Europe in the last few weeks. Clearly, such a situation has immediately generated a dramatic scenario in financial markets, carrying the need for intervention by governments and central banks worldwide.
To name but one, the European Stoxx 600 index dropped by nearly 30% in one month, offsetting last year's outstanding results. Among European countries, Italy showed the worst trend, as the FTSE MIB dropped by more than 27% since the middle of February, while French CAC 40 and German DAX fell respectively by 25% and 24% in the same time frame.
Naturally, the outbreak impacted Asian-Pacific and US financial markets as well. The oriental markets, stood as the most stricken: in the last month the S&P200 index recorded a drop of around 25%, while the indexes of major economies in Asia, SSE Composite Index, Nikkei 225, and Hang Seng, respectively rose by 1% and fell by 22% and 13%. In the US, instead, Dow Jones and Nasdaq lost respectively 20% and 12%.
Moreover, in the last few days stock markets have been undermined by an oil price shock. In a time in which the demand for oil is at the lowest level of the last few years, an increase in the supply would act as a severe cutter of the oil price. This is exactly what happened when Saudi Arabia suddenly announced a 25% increase in its oil production: Brent and WTI prices dropped by around 30%, the largest loss in the oil market since the Gulf War 1990s.
Central banks needed to respond quickly to contain such a complex situation and the FED announced a raise in liquidity in the market together with a possible additional cut in interest rates, after the one implemented on March 3rd that lowered the overnight interest rate by 50 bps reaching 1.25%.
Without waiting for too long, BoE cut its interest rate by the same amount (from 0.75% to 0.25%). How did the ECB react?
The ECB’s response
In response to the decisions of other central banks, the new ECB president Lagarde announced its first package to tackle the economic fallout from Covid-19 in a press conference on Thursday. Because of low margins of intervention due to historic low ECB rates, the announced measures do not involve a further interest rate cut but the decision to ramp up QE to inject additional liquidity into the market.
First, the ECB announced additional temporary LTROs (longer-term refinancing operation) at the average deposit rate and decided to apply more favourable terms to all outstanding TLTROs from June 2020 to June 2021 by reducing applied rates to a minimum bound of minus 75 basis points. By offering banks funding at attractive conditions, TLTRO programs aim at decreasing further the costs of borrowing for households and SMEs affected by the Virus.
To make sure counterparties can make full usage of the funding support they receive, the governing council has used its other role, that of bank supervision, to loosen pillar 2 capital requirement for European banks. Given the borrowed amount from the ECB, this will allow banks to inject higher liquidity in the real economy instead of cumulating cash for regulatory requirements.
Lagarde also announced an increase in the Asset purchase program (APP) by €120 billion by the end of 2020 to support favourable financing conditions. The higher demand for financial assets induced by the purchase should increase bond prices and positively affect the cost of financing for companies issuing bonds. We expect the current APP “to run for as long as necessary to reinforce the accommodative impact of low rates” Lagarde said during the press conference.
Lastly, we should expect ECB rates to remain unchanged until “inflation move towards its aim in a sustained manner”, which shouldn’t happen soon as decreasing oil prices incentive fears of deflation.
This is the first challenging decision for Lagarde and comes in a delicate context inherited from the previous mandate: interest rates are already at their zero lower bound and unconventional monetary policies have already been broadly exploited in the past. This decision further limits the ammunition at the disposal of the ECB but Lagarde seems certain of the urgency to intervene as she told EU leaders on a conference call on Tuesday that we risk seeing “a scenario that will remind many of us the 2008 financial crisis”. However, many economists believe that this is not the correct response. The risk is that further monetary easing is only going to increase risk premia because of increased expectations of a recession and will have no effect on consumers' demand affected by the virus. On the contrary, in this context of total lockdown aimed at preventing the spread of the virus, fiscal measures are more immediate and effective as they help companies and employees to meet the deadlines for their debt and mortgage payments. "At the current juncture, a vaccine would help more than another rate cut," Carsten Brzeski - head of macro research at ING - said on Tuesday to emphasize that there is little the ECB can do.
As this sceptical view seems shared by most analysts, we should not expect the recent trend in asset prices to be inverted following the ECB announcement. Market reactions keep showing big waves of sales on all asset classes including European banks despite being the ones benefiting the most from the monetary intervention. Maybe the market was expecting more from the ECB, or simply realized that the only thing that could stop the turmoil is a vaccine and certainly not monetary policy. For sure, a stronger quantitative easing will reveal useful only once the virus is defeated with other weapons.
Focusing on Italy
As of today, with 827 deaths and at least 12,462 people infected (numbers of March 11), Italy is the second World country by confirmed contagion cases. On March 9, Prime Minister Conte announced a national lockdown of all the local economic activities, which will last until the 3rd of April and it is likely to be extended. This strategical move, together with the effects of the virus itself, caused the country to rapidly enter a crisis.
What has first emerged is a supply-side shock. Indeed, given the strong reliance that Italian output has on the Chinese market (as it supplies many intermediate goods), the suspension of Chinese production caused many Italian businesses to be limited in their activities. Moreover, since the ECB does not have any influence on the supply-side, traditional monetary instruments are not effective. As a result, the GDP is expected to decrease between 9 and 27 billion euros. In the meantime, the necessity of substantial investments in the health system is boosting public spending and M&A operations, which were forecasted to be worth €20B in 2020, are going to experience a massive slowdown.
Clearly, pessimism has significantly increased and gave light to a bearish trend that let the FTSE MIB Index lose over 20% in less than two weeks. On the 9th of March, the BTP-Bund Spread reached 230 points due to massive sales of BTPs and a wave of purchase of German bunds that have a historically low rate of return.
The spread of the novel coronavirus (COVID-19) started in China in January and has been affecting Europe in the last few weeks. Clearly, such a situation has immediately generated a dramatic scenario in financial markets, carrying the need for intervention by governments and central banks worldwide.
To name but one, the European Stoxx 600 index dropped by nearly 30% in one month, offsetting last year's outstanding results. Among European countries, Italy showed the worst trend, as the FTSE MIB dropped by more than 27% since the middle of February, while French CAC 40 and German DAX fell respectively by 25% and 24% in the same time frame.
Naturally, the outbreak impacted Asian-Pacific and US financial markets as well. The oriental markets, stood as the most stricken: in the last month the S&P200 index recorded a drop of around 25%, while the indexes of major economies in Asia, SSE Composite Index, Nikkei 225, and Hang Seng, respectively rose by 1% and fell by 22% and 13%. In the US, instead, Dow Jones and Nasdaq lost respectively 20% and 12%.
Moreover, in the last few days stock markets have been undermined by an oil price shock. In a time in which the demand for oil is at the lowest level of the last few years, an increase in the supply would act as a severe cutter of the oil price. This is exactly what happened when Saudi Arabia suddenly announced a 25% increase in its oil production: Brent and WTI prices dropped by around 30%, the largest loss in the oil market since the Gulf War 1990s.
Central banks needed to respond quickly to contain such a complex situation and the FED announced a raise in liquidity in the market together with a possible additional cut in interest rates, after the one implemented on March 3rd that lowered the overnight interest rate by 50 bps reaching 1.25%.
Without waiting for too long, BoE cut its interest rate by the same amount (from 0.75% to 0.25%). How did the ECB react?
The ECB’s response
In response to the decisions of other central banks, the new ECB president Lagarde announced its first package to tackle the economic fallout from Covid-19 in a press conference on Thursday. Because of low margins of intervention due to historic low ECB rates, the announced measures do not involve a further interest rate cut but the decision to ramp up QE to inject additional liquidity into the market.
First, the ECB announced additional temporary LTROs (longer-term refinancing operation) at the average deposit rate and decided to apply more favourable terms to all outstanding TLTROs from June 2020 to June 2021 by reducing applied rates to a minimum bound of minus 75 basis points. By offering banks funding at attractive conditions, TLTRO programs aim at decreasing further the costs of borrowing for households and SMEs affected by the Virus.
To make sure counterparties can make full usage of the funding support they receive, the governing council has used its other role, that of bank supervision, to loosen pillar 2 capital requirement for European banks. Given the borrowed amount from the ECB, this will allow banks to inject higher liquidity in the real economy instead of cumulating cash for regulatory requirements.
Lagarde also announced an increase in the Asset purchase program (APP) by €120 billion by the end of 2020 to support favourable financing conditions. The higher demand for financial assets induced by the purchase should increase bond prices and positively affect the cost of financing for companies issuing bonds. We expect the current APP “to run for as long as necessary to reinforce the accommodative impact of low rates” Lagarde said during the press conference.
Lastly, we should expect ECB rates to remain unchanged until “inflation move towards its aim in a sustained manner”, which shouldn’t happen soon as decreasing oil prices incentive fears of deflation.
This is the first challenging decision for Lagarde and comes in a delicate context inherited from the previous mandate: interest rates are already at their zero lower bound and unconventional monetary policies have already been broadly exploited in the past. This decision further limits the ammunition at the disposal of the ECB but Lagarde seems certain of the urgency to intervene as she told EU leaders on a conference call on Tuesday that we risk seeing “a scenario that will remind many of us the 2008 financial crisis”. However, many economists believe that this is not the correct response. The risk is that further monetary easing is only going to increase risk premia because of increased expectations of a recession and will have no effect on consumers' demand affected by the virus. On the contrary, in this context of total lockdown aimed at preventing the spread of the virus, fiscal measures are more immediate and effective as they help companies and employees to meet the deadlines for their debt and mortgage payments. "At the current juncture, a vaccine would help more than another rate cut," Carsten Brzeski - head of macro research at ING - said on Tuesday to emphasize that there is little the ECB can do.
As this sceptical view seems shared by most analysts, we should not expect the recent trend in asset prices to be inverted following the ECB announcement. Market reactions keep showing big waves of sales on all asset classes including European banks despite being the ones benefiting the most from the monetary intervention. Maybe the market was expecting more from the ECB, or simply realized that the only thing that could stop the turmoil is a vaccine and certainly not monetary policy. For sure, a stronger quantitative easing will reveal useful only once the virus is defeated with other weapons.
Focusing on Italy
As of today, with 827 deaths and at least 12,462 people infected (numbers of March 11), Italy is the second World country by confirmed contagion cases. On March 9, Prime Minister Conte announced a national lockdown of all the local economic activities, which will last until the 3rd of April and it is likely to be extended. This strategical move, together with the effects of the virus itself, caused the country to rapidly enter a crisis.
What has first emerged is a supply-side shock. Indeed, given the strong reliance that Italian output has on the Chinese market (as it supplies many intermediate goods), the suspension of Chinese production caused many Italian businesses to be limited in their activities. Moreover, since the ECB does not have any influence on the supply-side, traditional monetary instruments are not effective. As a result, the GDP is expected to decrease between 9 and 27 billion euros. In the meantime, the necessity of substantial investments in the health system is boosting public spending and M&A operations, which were forecasted to be worth €20B in 2020, are going to experience a massive slowdown.
Clearly, pessimism has significantly increased and gave light to a bearish trend that let the FTSE MIB Index lose over 20% in less than two weeks. On the 9th of March, the BTP-Bund Spread reached 230 points due to massive sales of BTPs and a wave of purchase of German bunds that have a historically low rate of return.
Graph taken from Borsa Italiana
Graph taken from Il Sole 24 ORE
The Italian Government, together with banks and the European Union, is attempting to sustain the national economy, through what the Prime Minister Conte defined a “massive shock therapy”. In fact, ABI, the Italian Banking Association, has already given the chance of adjusting the deadlines of short-term loans to micro, small and medium enterprises and first house mortgages that meet the requirements are suspended in case of job loss, death, disease, redundancy fund, with an extension of the Solidarity Fund. Along with the implementation of restrictive measures, a support package of €7.5B was dedicated to families and businesses. These strategies would necessarily increase the Italian deficit, giving rise to a borderline situation, also considering that before the outbreak Italy already had a public debt of 134% of the country GDP, way higher than the maximum of 60% allowed by the Stability and Growth Pact and the European Fiscal Compact.
For this reason, Conte is asking for comprehension from the EU and he is seeking an agreement on a coordinated fiscal stimulus, encouraging the other leaders to use all available tools at their disposal, including bending fiscal and state aid rules.
As the situation becomes worse, the initial funds resulted to be inadequate. On Wednesday the Government announced the availability of a cushion of €25B to fight the crisis, of which €12B will be stationed in the next few days in healthcare, income and employment support, liquidity injection and tax incentives. This amount of debt would lead deficit to reach the 3% European limit over GDP.
During the conference held on March 12, investors were waiting for Christine Lagarde, President of the ECB, to answer several questions on the fiscal path undertaken by Italy, including the €25B plan. After emphasizing the importance of a rapid, strong, collective approach, she reminded that the three principal means made available by the EU - unlimited and generous access to liquidity, attractive long term refinancing operations and a €120B envelope for special asset purchase program – have no “predetermination of location” and will be certainly useful for Italy.
When asked what can EU do if the spread increases, Lagarde answered that the focus right now has to be placed on encouraging the enterprises in financing, in the hope that credit will keep flowing, and that spread will only be of secondary concern to the single countries. She also said that the sooner a country responds to the crisis with the implementation of an action plan, the sooner it will get out of the crisis. Given that, as of today, Italy is the only country to have implemented such a strategy, the speech should have created optimism among investors. However, during the conference the FTSE MIB showed a -9% return and, a few hours later, the spread sharply increased topping 262 bps. Probably, investors are still wondering whether the measures adopted are enough to grant a solid aid to Italy and the large recourse to debt will not exacerbate an already fragile financial situation.
Nicola Bulgarelli, Silvia Guggiana, Lorenzo Masserini
With the supervision of Roberto Di Stefano
For this reason, Conte is asking for comprehension from the EU and he is seeking an agreement on a coordinated fiscal stimulus, encouraging the other leaders to use all available tools at their disposal, including bending fiscal and state aid rules.
As the situation becomes worse, the initial funds resulted to be inadequate. On Wednesday the Government announced the availability of a cushion of €25B to fight the crisis, of which €12B will be stationed in the next few days in healthcare, income and employment support, liquidity injection and tax incentives. This amount of debt would lead deficit to reach the 3% European limit over GDP.
During the conference held on March 12, investors were waiting for Christine Lagarde, President of the ECB, to answer several questions on the fiscal path undertaken by Italy, including the €25B plan. After emphasizing the importance of a rapid, strong, collective approach, she reminded that the three principal means made available by the EU - unlimited and generous access to liquidity, attractive long term refinancing operations and a €120B envelope for special asset purchase program – have no “predetermination of location” and will be certainly useful for Italy.
When asked what can EU do if the spread increases, Lagarde answered that the focus right now has to be placed on encouraging the enterprises in financing, in the hope that credit will keep flowing, and that spread will only be of secondary concern to the single countries. She also said that the sooner a country responds to the crisis with the implementation of an action plan, the sooner it will get out of the crisis. Given that, as of today, Italy is the only country to have implemented such a strategy, the speech should have created optimism among investors. However, during the conference the FTSE MIB showed a -9% return and, a few hours later, the spread sharply increased topping 262 bps. Probably, investors are still wondering whether the measures adopted are enough to grant a solid aid to Italy and the large recourse to debt will not exacerbate an already fragile financial situation.
Nicola Bulgarelli, Silvia Guggiana, Lorenzo Masserini
With the supervision of Roberto Di Stefano