Rabobank: “Markets Must Now Accept: This Is War”

Submitted by Michael Every of Rabobank

We can ill afford another Klendathu

Markets must now accept: this is war.

How else does one react to the slew of international borders being closed; to the slew of school and businesses within said borders being closed; to reports that elderly people may to self-isolate for months in the UK; that the army may be needed to ensure we get food; that companies are being co-opted by governments to fight the virus as now required (“Build ventilators!” “Make virus tests free!”); that there is talk of supply-chains and virus experts attempting to be poached by the US to work solely for them; and, contra-wise, for key virus-related goods being on-shored or even nationalised, even in Germany?

How else does one react to the scale of staggering scale and breadth of uncosted fiscal packages being rolled out, even in the US (though this has an end-year sunset clause – if you want to believe that). Believe me, those fiscal bills are going to get bigger and bigger. Governments are going to have to support households, the self-employed AND businesses large and small through this all, or we face a domino-style economic collapse. Many are saying they will, or suggesting they will, even the EU’s somnambulant Khrushchev, Angel Merkel.

And what else but war, or utter calamity, would see the Fed not able to wait even a further couple of days to deliver its latest 100bp bazooka cut? (We are now at the zero lower bound again, as our Fed Watcher Philip Marey has been saying all along we would be in 2020.) What else could see the Fed offer up another USD700bn in QE, which on top of the recent liquidity pledges made now mean that USD5.5 trillion is available, if needed (as well as letting banks borrow from the discount window for 90 days and slashing reserve requirement ratios to zero!)? That is genuinely the kind of cash a war usually destroys. Even the smaller central banks are at it: the RBNZ has just slashed rates to 0.25%, once again showing itself more nimble than the RBA (NZD dipped sub-60 for a moment). Indeed, it would seem that with a few exceptions, we are all going to be at the zero lower bound imminently.

Amazingly, China might be one of those exceptions because of the deep debt-and-inflation-and-fear-of-a-CNY-collapse hole that they are already stuck in. Yes, the PBOC has cut its Reserve Requirement Ratio again – but that looks small beer now, especially when retail sales for January AND February, hence flattering the data upwards a lot, was -20.5% y/y (bless those Bloomberg survey respondents whose median guess was -4%!), industrial production was -13.5%, fixed asset investment was -24.5%, and even unemployment was up to 6.2%: who would ever have predicted that China would face problems shovelling in enough liquidity, and perhaps even enough fiscal stimulus, and have a higher cost of capital than the rest of the world?

Yet that certainly doesn’t mean CNY will in any way be pushing USD aside, even if so: quite the opposite. Indeed, alongside this barrage of latest virus-fighting measures we continue to see signs of enormous stress in the markets. Most obviously: S&P futures are limit down following the Fed move, which is hardly a ringing endorsement; while 30-year US Treasuries are back over 1% at 1.26%, vs. just 0.27% for the 2-year, the 10-year is down to 0.65% again, a 31.4bp move today that does not suggest imminent reflation on the back of all this fiscal and monetary fire-power; the superstructure of the global credit markets continues to groan worryingly; FRA-OIS spreads are not where one would want them to be; and cross-currency basis swaps continue to point to a demand for USD. Need I add, the dash for dollars and for cash are again what one would expect to see during a war?

In short, the big policy guns have now all been rolled out and fired. Short of open helicopter money entering playing The Flight of the Valkyries over loudspeaker, there is little left to do already. (“I love the smell of MMT in the morning! Smells like victory!”) And those helicopters are surely coming too if one reads the latest secret UK Public Heath England report obtained by the media, which says that this crisis will not be over in Q2, or even H2. Rather, it is expected to last until Spring 2021, see 80% of the population infected, 7.9m hospitalised, and anywhere from 318,660 to 531,100 deaths – assuming the health service is not over-run and the mortality rate hence stays around 1% max.

So we have an array of monetary and fiscal weapons. But these are likely to face the same fate as 1997’s Starship Troopers did in their first battle with the bugs at Klendathu if they do not understand that nature, not the business cycle, is the most dangerous opponent. (Spoiler: the bugs win big over the arrogant humans.)

Even the jaw-dropping concept of the central banks and governments making everyone whole until this crisis passes, with all the equally mind-bending socio-economic and socio-political implications, is not the real battle. The real battle is the virus. Even helicopter money would just be palliative to keep can-kicking until we can kick the virus.

Further, in a real war markets are right to sell-off. Unlike our recent, comfortable experiences of conflict, fought by people we never meet socially in places we never want to go, the long-run history of war is of blood and tears. Wars destroy economies. They smash currencies. They topple regimes. They remake demography. They shift borders. They rewrite social contracts. They even change national identity and psychology.

If this is a true global epidemic that lasts until we get a vaccine in 18 months (and not due to the “herd immunity” that the UK seems to be chasing away from the rest of the herd), then the cost of fighting it is going to be high for everyone. A whole generation, perhaps two, of market ‘teenage-scribblers’ are unaware what this is really likely to mean: there are still voices out there suggesting this will all be over in weeks and a V-shape recovery will return us to normal: public health officials strongly disagree. Who knows best?

Yes, in the long run one wants to back humanity – science has a great track record when applied during war: the question is how much is lost and destroyed before then. Moreover the alternative logical end-point, no working vaccine and no herd immunity, as with flu, is that we will all have to accept that once we reach old age we probably won’t live that long. Surely no takers there.

However, for now please prepare yourselves carefully – and in markets terms that means ignore Steven Mnuchin and his “I see no recession” call: ‘We can ill afford another Klendathu’.