More fiscal and creative policy needed to address Covid-19 crisis as RSM’s UK Financial Conditions Index dips towards 2008/09 levels

Joe Brusuelas, RSM’s chief economist comments: 

As the global Covid-19 health pandemic intensifies, and financial conditions in the UK drop to levels not seen since the 2008-09 global economic downturn (according to RSM’s Financial Conditions Index), a more robust set of fiscal outlays and creative monetary policy will be required to address the current crisis.

The Covid-19 has caused economies across to globe to adopt self-distancing as the de-facto international global public health policy to mitigate the spread of the disease. Unfortunately, that policy requires putting national economies into a coma to save lives. 

Simultaneously, the domestic UK economy has suffered supply, demand and a four standard deviation financial shock in a matter of days that has likely ushered in the end of the current business cycle. 

The sharp shocks will result in an outsized decline in growth in the first and second quarters of the year, which will meet the technical definition of a recession. While, the fiscal and monetary policies put in place by the government and the Bank of England are laudable, they will likely not be enough. 

This most recent collapse (as highlighted in the Financial Conditions Index below), was to be expected. There have already been over 760 deaths in the UK, amid 14,580 (as of March 27) reported cases of the Covid-19 virus since the start of the year. 

Financial conditions index 

But it was only this week (March 23) that the government required people to stay in their homes, this despite earlier lockdowns in Asia and on the Continent that appeared to have slowed Covid-19’s spread. A model of cumulative cases in the UK shows that the number of cumulative cases doubled from the time that week that Boris Johnson took steps to limit social interaction. It seems plausible for the cases to rise along that path for the next 2-3 weeks until the quarantine takes full effect.

The quarantine of the public, the lack of non-essential spending, and the shutting of shops and businesses are bound to result in waves of demand shocks across the UK economy. The loss of income, if not replaced, will continue to loop back throughout the real economy and into its financial underpinnings. That’s where financial conditions play its part. 

A loss of confidence in the economy increases the compensation demanded by lenders to account for default risk, resulting in the loss of market makers and the loss of liquidity necessary for short-term transactional requirements of day-to-day business. In the long-term, borrowers and lenders lose confidence in the expected return on investment, stifling the ability of an economy to grow.

The monetary authorities have learned to respond to these confidence killers with quick action. Still, while the central banks can infuse financial systems with liquidity and reduce interest rates to promote investment, they can’t replace lost income or lost labour or replace the productivity of capital investment. Now it’s time for the fiscal authorities to quickly maintain household incomes while we wait for a vaccine. The recent announcements from the Chancellor of the Exchequer are welcome but may need to go further. These are indeed frightening economic times.

Performance of index components

The RSM Financial Conditions Index is an aggregation of the performance of eight indicators in the UK currency, equity, money and bond markets. Components include the British pound-euro exchange rate and its volatility, the FTSE 100 and its volatility, the UK Ted and Libor/OIS money-market spreads, and gilt and U.K. corporate bond spreads.

FX Market -- The pound has lost 8% of its value since prior to the equity market crash at the end of February. Losses were equally against the euro and a basket of trading-partners’ currencies, all on higher volatility. This loss of buying power is likely to have further negative implications for manufacturers and household balance sheets, acting as a further drag on profit margins and consumer spending in the months ahead. 

Equity Market
The FTSE 100 lost an incredible 21% of its value since February 21, on higher volatility. This decline followed the loss of confidence in the ability of US authorities to manage the health crisis, which has afflicted the world’s major stock exchanges. 

Money Markets
Interest rate spreads between credit-dependent money-market rates and government guaranteed securities act as the canary-in-the-coal-mine for liquidity considerations. As the figure below illustrates, money-market spreads tend to blow out during crisis periods, with the current spreads approaching liquidity constraints during the European Debt Crisis.  

Bond Market
Ten-year gilt have yielded less than 0.50% since the equity market crash and the government yield curve remains inverted. That signals concern for both short-term and long-term growth. And the corporate bond market is pricing in substantially more credit risk than before the coronavirus outbreak.

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