Coronavirus Selloff Resembles Lehman In One Key Respect. Will The Emergency Fed Cut Change That?

While it’s true that the action across rates and equities has been rather frantic over the last couple of weeks, there’s no real ambiguity about what, exactly, is taking place.

“It is becoming clear that this is a demand shock and as such, its effects are expected to be offset (at least partially) by rate cuts”, Deutsche Bank’s Aleksandar Kocic writes, in a new note. “The price action is rather unambiguous about it”.

The Fed, of course, delivered a 50bps inter-meeting cut on Tuesday, the first emergency action since the crisis, but stocks subsequently plunged.

Powell’s press conference found the Fed chair acknowledging that “a rate cut can’t fix supply chains”, and he said the committee hadn’t actively discussed additional measures yet. “We do like our policy stance”, he insisted. “It’s appropriate”.

The Fed will probably cut again at the regular meeting later this month, which will surely feature downgraded economic assessments to reflect the reality of the virus and how various containment measures will impact growth.

In his Monday note, Deutsche’s Kocic wrote that during demand shocks (or expected demand shocks), “the underlying mode of the market is characterized by increasing coordination between rates and risk assets”.

In other words, he said, “risk goes into a free fall [and] rate cuts act as a parachute that slows down the fall”.

The effectiveness of the “parachute” (as Kocic puts it) is simply the relative speed of the decline in risk assets (in this case, SPX) per unit of yield change.

If rate cuts are effective, the speed of the decline is slower. If, however, “rate cuts are ineffective, e.g. the recession is too deep that rate cuts cannot slow down selloff in risk, like in 2008, the drop in equities per unit of yield decline is large”, Kocic went on to say.

Have a look at the following regression which illustrates the dynamic across various downturns compared to the current scare:

(Deutsche Bank)

As Kocic explained, “the two periods of effective rate cuts both fall onto the same line with beta around 6.5 [while] the first two months of the 2008 financial crisis have the rate of S&P decline about three times faster [with] beta at 22”.

Although the scope of the selloff in equities is obviously nowhere near as extreme as the dark days around Lehman’s collapse, by this measure, at least, the coronavirus scare nearly matches the financial crisis. “When viewed in units of yield response, the two periods are comparable with roughly the same beta”, Kocic pointed out.

Why is that? We can all argue about whether or not COVID-19 truly represents an end-of-days-type biological threat, and it’s certainly true that, in a worst-case economic scenario, a global downturn is possible. But the immediate risk to the financial sector (narrowly construed) simply isn’t comparable to September/October 2008.

The difference, Kocic wrote Monday, is the absence of actual rate cuts.

“In 2008, decline of short rate was on the back of actual rate cuts [whereas] now, decline in 2Y rates is driven by the expectations of rate cuts”, he went on to write, adding that “although the market is pricing in lower rates, the Fed would have to deliver actual cuts on top of those expectations in order to slow down the selloff in risk”. Specifically, he notes that “another 50-75bp decline in 2Y swaps rate would bring us closer to the beta = 6.5 line corresponding to the regime of cyclical downturns”, shown in the visual above.

Again, that was on Monday. Fast forward to Tuesday, and the Fed has given us 50bps. The committee will likely deliver more later this month.

Will it be enough to put risk assets back on a “normal” trajectory, consistent with cyclical downturns? Or is it time to put on the tinfoil hats and stockpile canned goods?

That’s a question you’ll have to answer for yourself.