The early 2020 onset of the novel coronavirus (COVID-19) pandemic brought chaos to the financial markets. From its initial detection in Wuhan, China to the outbreak's late-February global explosion, the virus unhinged markets worldwide. No asset class was spared from COVID-19's wrath, beit equities, commodities, bonds or currencies.
In an attempt to mitigate the negative economic implications of the coronavirus, central banking authorities turned to aggressive monetary policies. Led by the U.S Federal Reserve (FED), central banks around the globe fought massive uncertainty through quantitative easing (QE). As the programs were put into place, this was the multi-trillion dollar question: can QE stop the COVID-19 economic fallout?
Central Banks And Quantitative Easing (QE)
QE is a form of monetary policy designed to promote market liquidity in the interbank and commercial lending sectors. In order to accomplish this objective, central banks practicing QE cut interest rates, issue vast quantities of low interest loans and become active in the capital markets. These three functions are aimed at reinforcing confidence in the financial system by promoting market liquidity.
Lessons From The 2008 Crisis
Although QE is a controversial monetary policy, it does have a successful track record, including when it was instituted during the financial crisis of 2008. A result of unfettered subprime lending and reckless use of consumer debt, the crisis of 2008 brought the world's credit markets to a virtual standstill. The result was a prolonged recession caused by a "frozen" interbank lending environment and lagging consumption. In an attempt to "jump start" economic growth, central bankers turned to QE as the answer.
At the tip of the spear in the crisis of 2008 was the United States FED. From 2008-2015, the FED executed three rounds of QE, purchasing trillions in government bonds and mortgage-backed securities. By year end 2015, the FED's balance sheet had swelled to US$4.5 trillion. The QE programs were deemed successful, with U.S. unemployment falling sharply and gross domestic product (GDP) growth being restored for the period.
Upon the late-February and March 2020 onslaught of the COVID-19 pandemic, financial markets exhibited turbulence not seen in more than a decade. From 24 February to 31 March, the world's capital markets became chaotic as investors evaluated the potential impact of COVID-19. Among the key events were several record-setting single-day rallies and crashes in the Dow Jones Industrial Average (DJIA), all-time lows for U.S. Treasury yields and a USD Index rally to 36-month highs. As the COVID-19 outbreak intensified, asset classes across the board became routinely plagued by extreme volatility.
Restoring Pricing Stability
The primary function of any central bank is to promote pricing stability. As an example of this point, the Bank of England (BoE) considers its mission to be the following:
"The Bank's monetary policy objective is to deliver price stability and, subject to that, to support the Government's economic objectives including those for growth and employment. Monetary stability means stable prices and confidence in the currency."
During the immediate aftermath of COVID-19 reaching pandemic proportions, the U.S. FED took action to restore pricing stability. On 3 March 2020, the FED reduced the Federal Funds Target Rate by ½ point to 1.00%-1.25% in an emergency policy move. Nearly two weeks later, on 15 March, the FED elected to drop the Federal Funds Target Rate to 0.0%-0.25% in an attempt to calm the markets.
Aside from the dramatic rate cuts, the FED also began increasing the money supply via a sweeping QE program. Large-scale bond repurchases, interbank loans, corporate loans and currency swaps were executed. Under the new policy of unlimited QE, the U.S. FED began injecting trillions of dollars into the financial system to manage the COVID-19 economic ramifications.
Will QE Stop Coronavirus (COVID-19) Economic Fallout?
Although QE was credited with turning the tides of the 2008 financial crisis, it does have some detractors. Critics contend that its positive effects are temporary and that QE poses major risks to the morality of government, currency stability and the future course of monetary policy.
However, QE does two things that foster recovery from an economic shock: it ensures market liquidity and it promotes confidence in the financial system. Through making sure that there is enough money available to lend, spend and save, QE can stabilise asset pricing. In the weeks that followed the FED's institution of unlimited QE, many asset classes showed signs of recovery. From 23 March-3 April 2020, many of the world's capital markets returned to a state of calm:
- Equities: The Dow Jones Industrial Average (DJIA) and Standard and Poor's 500 (S&P 500) each posted two-week rallies of more than 14% from panic lows.
- Currency: Over the course of the COVID-19 outbreak, the United States dollar (USD) became a preferred safe-haven asset among investors. From 23 March to 3 April, most major forex pairs traded within established ranges.
- Commodities: In the wake of a stronger USD, commodity prices lagged. Following the institution of unlimited QE, a 16.5% gain in West Texas Intermediate (WTI) crude oil paced commodity product performance.
Past performance is not an indicator of future results.
As the COVID-19 pandemic intensified, a majority of economists began projecting a worldwide recession as inevitable. U.S. unemployment rates were estimated to spike as high as 32% and global GDP growth rates were to fall from 2.6% to 1.9% in the virus aftermath. While unlimited QE reinforced stock market valuations in the short-term, its broader economic impact will take time to measure.
At the time of this writing (9 April 2020), the aggregate impact of QE on COVID-19 economic fallout remains unknown. However, if the crisis of 2008 was any indication, the increased liquidity afforded to the global financial system is likely to stimulate economic activity. Unfortunately, a multitude of variables persist regarding the containment and eradication of the COVID-19 contagion. Until COVID-19 is no longer a factor in the world economy, the utility and form of policies such as QE will continue to evolve.
For the past decade, central banks have sought to manage economic downturns through policies of quantitative easing (QE). Such programs have been adopted in Japan, the European Union and United States, each with varying degrees of success.
Amid the COVID-19 pandemic, central banks around the world sought to limit the economic damage via QE. Even though QE has a positive track record, it remains unclear whether the policy can stop the coronavirus economic fallout. Ultimately, only time will tell.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…