Will coronavirus make the Fed sick?

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Just when everyone thought there would be little drama at this week’s Federal Open Market Committee meeting, the coronavirus has infected the broader markets. Experts still say monetary policy will be immune for now.

“Although the coronavirus news rightly has everyone worried, I doubt the FOMC will make it a big part of their deliberations on Wednesday,” said Peter Ireland, an economics professor at Boston College and a member of the Shadow Open Market Committee.

While it is likely to come up at Chairman Jerome Powell’s press conference, Ireland said Powell's answer will likely be: “while the Fed is watching the developments on the spread of the disease just like it watches all other news that can potentially impact the U.S. and global economies, for now the movements in stock prices have been relatively small in percentage-point terms and seem to reflect fears of the worst possible outcomes instead of the most likely outcomes.”

Financial asset prices can be volatile, he added, and “if better news comes out tomorrow suggesting the spread of the virus has been more contained, then stock and bond prices are going to snap back to where they were before.”

Fed officials “have made it clear that it's going to take a lot to knock them in either direction away from being on hold until after the November elections,” Ireland said. “I just don't see the news as being nearly enough to force the Fed to change its policies.”

“Continued uncertainty regarding the life cycle of the new coronavirus contagion is flattening the yield curve as a flight to quality is driving down treasury yields,” said Bryce Doty, senior portfolio manager at Sit Fixed Income Advisors. “With the Fed expected to stay on hold this week, shorter-maturity bond yields have declined less than long-term maturities.”

He added, “the Fed will likely give a nod to the hit to global growth from the coronavirus outbreak which could re-steepen the curve as investors could take it as opening the door to a possible rate cut in the future.”

And with the yield curve flattening Monday and the threat of it “inverting once again,” Doty said, “some investors think the Fed may actually increase the rate being paid on excess reserves from 1.55% to 1.60% all because the actual fed funds rate has gone 0.01% below the rate being paid.”

But such a move “would just make the repo problem worse by increasing the incentive for banks to hoard cash at the Fed and cement the Fed as the lender of first, not last, resort for daily liquidity. With the yield curve already inverted from T-Bills to the five year, we just don’t see a rate increase to the interest on excess reserves making sense.”

Despite the flattening, “It’s unlikely Treasuries invert today, but over the days and weeks ahead, the curve will react to additional spread of the virus,” said George Boyan, president of Leumi Investment Services. The disease “has surprised the financial markets and equity and bond markets are under pressure.”

While previous health epidemics have had “a substantial effect on the global macro economy,” he said, “it is still too early to determine if coronavirus rises to the levels of prior SARS or ebola scares.”

The Fed “will be watching” the situation.

But even if the curve inverts, "the fundamental lesson we learned from the yield inversions last summer is that they don't always foreshadow an impending recession,” said Robert Frick, corporate economist at Navy Federal Credit Union. “Last summer anxieties from the trade war caused foreign money to pile into U.S. Treasuries, especially at the long end, driving up prices and so driving down yields and causing inversions. Now concerns of the coronavirus could cause inversions as well. If yield curves were steeper to begin with, and not flattened as they are by weak economic growth globally and negative yields in Europe and Japan, these threats would not cause inversions. So we shouldn't read too much into coronavirus-induced inversions, should they occur."

Steve Skancke, chief economic advisor at Keel Point and former Treasury staffer, agreed. The “U.S. market will recover as soon as investors can see that impact to U.S. economic growth and company earnings is not material,” he said on Twitter.

“Whether the market reaction to the coronavirus will be short-lived or extended further remains a guessing game for now,” Hussein Sayed, chief market strategist at FXTM, said in a market comment. “The bottom line is how much global economic output will be wiped out, and so far, no one knows the answer.”

“Epidemics do not typically have a long-term effect on financial markets,” noted Bill Zox, portfolio manager and chief investment officer, fixed income, at Diamond Hill Capital Management. “While the yield curve has flattened, I do not expect a sustained inversion or a material change in Fed policy due to the coronavirus. Equity and interest rate volatility was too low and I do expect higher volatility to be sustained.”

“If the Wuhan coronavirus is mentioned by the Fed (big IF) it is more likely to come out in the post-meeting press conference Q&A rather than in the official statement,” according to Jeff MacDonald, managing director and head of fixed income Strategies at Fiduciary Trust Company International. “While there are ‘potential’ macroeconomic implications to this virus breakout, it is too early to assess what that impact might be and it is certainly premature to expect an easier stance on monetary policy based on this development in these early days.”

While the Fed will keep an eye on the yield curve, it “will primarily focus on the hard data released on the economy to” determine monetary policy, he said.

New home sales fell 0.4% in December to a seasonally adjusted 694,000 pace from a revised 697,000 rate in November, first reported as 719,000.

Economists polled by IFR Markets expected sales to gain to 730,000 in the month. Sales have fallen for three consecutive months.

Manufacturing in Texas accelerated in January, as measured by the Federal Reserve Bank of Dallas’ Texas Manufacturing Outlook Survey.

The production index climbed to 10.5 from 3.6, and the new orders index rose to 17.6, a 15-month high, said Emily Kerr, Dallas Fed senior business economist. “Company outlooks were largely unchanged, though the index measuring uncertainty around those outlooks retreated further.”

The general business activity index narrowed to negative 0.2 from negative 3.2 a month earlier, while the company outlook rose to 1.9 from 1.3.

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