Economic Update QuarterlyLawry Knopp, VP-Funding & Hedging
Fears over the spread of the coronavirus have caused governments around the world to take drastic action to control the outbreak. In China, the number of new cases has leveled off significantly over the past two to three weeks, but it required a near total shutdown of their economy since late January to slow the rate of transmission. Experts are watching China, and more recently Italy, as a potential gauge of how the spread of the virus may develop in the U.S. and impact the economy.
With the decrease in the reported number of new cases in China, indications are the Chinese government may soon ease travel restrictions in some of the harder hit areas as it works to slowly restart economic activity. The rate of new cases in Italy, France, Germany and Spain continues to accelerate, but at a slower pace. Government authorities indicate a similar curve for an increase in the number of new cases in the U.S. There are signs the near-quarantine of the entire population is slowing the spread of the virus. However, the limited number of tests available is hampering the effectiveness of identifying and containing the virus. This will improve as the number of test kits increases.
For the past several weeks, market uncertainty has been extreme and the major U.S. equity markets are going through the worst downturn since 2008 and 1987. Flight-to-safety trading has pushed U.S. Treasury securities yields to new lows as investors seek return of principal over return on principal. Oil prices have fallen sharply with the price of WTI crude indicated at around $22 per barrel, from a recent high of $62. We are about seven weeks into the current downturn with the S&P 500 Index down almost 23% from its high of 3,386 on Feb. 19, 2020. For reference, it took the S&P 17 months to find the bottom during the 2008 financial crisis and 3.5 months during the 1987 crash. It’s possible the index could go lower as more is learned about the economic impact of the virus.
Monetary policy and fiscal policy efforts are moving quickly in an attempt to soften the expected impact to the U.S. economy. The estimated amount of monetary stimulus is around $4 trillion, with multiple programs established by the Federal Reserve to provide ample liquidity to lenders as it widens the types of assets it is willing to purchase. The amount of fiscal stimulus from the federal government is $2 trillion, made up of programs to support employment insurance and assistance, and sectors of the economy severely impacted by the economic shutdown.
Officials are hopeful the economy will quickly respond to the measures being put in place and we will experience a V-shaped recovery. It is possible these measures could be increased or expanded if the economy were to continue to deteriorate as we get into the second half of the year.
Naturally, the range of projections for the economic impact are wide at this time as statistics are being gathered. Gross domestic product growth for 2020-Q1 is expected to be near zero with the annualized rate of decline in Q2 projected to be much more dramatic, possibly as deep as 20% to 30%. The unemployment rate is expected to increase significantly. During the 2008 financial crisis, the unemployment rate topped out at 10% as the number of people out of work increased by nearly 8 million from January 2008 to October 2009. The current situation may be more difficult and may take only a few months to reach the highs of 2008-09.
The decline in the European and U.K. economies is expected to be similar to the U.S. Foreign central banks are actively implementing policies to cushion the blow to economic growth. Increased demand for U.S. dollars, as people view the dollar as a safer currency, has caused a shortage of dollars and hampered global trade. The Federal Reserve responded by establishing temporary swap lines with many of its major trading partners to address the issue. This has helped alleviate some of the pressure and facilitated the free flow of goods and services between countries, which often settle the transactions in U.S. dollars. Neither China nor Russia has swap lines set up with the Federal Reserve, and they are running low on U.S. dollars. This may make it more difficult for these countries to reignite their economies, which may force them to sell some of their holdings of U.S. Treasury securities to acquire U.S. dollars.
View on Interest Rates
U.S. Treasury yields are at historic lows with the 2-year yield down 125 basis points from Feb. 6 to 0.22%. The 10-year yield is down nearly 100 basis points to 0.67%. Many factors are in play as we go forward. The current level of economic uncertainty and market disruption will likely keep the 2-year yield under 0.60% for the next few months, depending on how sharp the decline in the economy is and the size of the monetary stimulus provided by the Federal Reserve. It will be difficult for 2-year yields to move higher until the market believes the Fed is considering an increase in policy rates, and that is likely a 2021 event at the earliest. It’s a similar outlook for the 10-year Treasury yield, likely staying under 1.25% for the rest of 2020.
Factors that could reshape this outlook would need to consider how the U.S. Treasury will finance the $2.2 trillion fiscal stimulus plan. Also, a large sale of Treasury securities by China could affect this outlook. If the economy responds quickly to the measures implemented by policymakers, robust growth could cause the outlook for inflation to be a concern and cause the Fed to reverse course sooner than expected.
The United States has faced many difficult times in the past. I am confident the American people will pull together to meet the challenge before us with determination, ingenuity and tenacity.
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