Financial markets in freefall

Hamid Yahyaei
Michael Yiannakis
19 March 2020
Macquarie Business School


Measures taken to halt the worst share market sell off since the 1987 crash are not working. Are we heading towards financial oblivion?

Financial markets are forward-looking and the story they see unfolding over the next few months is not a pretty one as central banks and policy makers can’t seem to stop the bleeding.

Markets rattled: investor panic has sparked a massive sell-off with billions of dollars wiped off investments.

Global markets have experienced their worst performance since the 1987 share market crash.

The ASX 200 plunged around 23 per cent in the first two weeks of March and the Dow Jones Industrial Average fell over 30 per cent in just over a month, wiping out all the gains made in the US since the inauguration of President Donald Trump in January 2017.

Hamid Yahyaei, from the Department of Applied Finance at Macquarie Business School, says central banks have been quick to provide signals to investors that they are willing to do whatever it takes to stabilise markets, but the worldwide COVID-19 pandemic has undermined most of that work.

“Central bank stimulus since the global financial crisis has resulted in extraordinarily low interest rates, especially among government bond yields which act as benchmarks for other securities. As such, valuations across virtually every asset class leading into this new crisis were extremely stretched and vulnerable to any unexpected shock,” Yahyaei says.

“What concerns markets, however, is the sheer uncertainty that true ‘black swan’ events such as the coronavirus can unleash. No matter how much stimulus central banks provide, the forward-looking nature of financial markets will see past short-term liquidity operations to decipher expectations of future economic conditions. No matter how much money is pumped into the system, if households significantly reduce their spending and we see declines in consumption, corporate profitability will deteriorate and impact valuations.”

Safe haven assets

Yahyaei, who previously worked as an analyst at the Reserve Bank of Australia and Spectrum Asset Management, says uncertainty breeds aversion to taking risk, and heightened risk aversion promotes a rotation in safe-haven assets (such as cash and government bonds), sparking sell-offs in riskier assets such as equities and corporate bonds as investors crystallise profits in fear of losses.

In terms of safe haven assets, money is pouring into US dollar investments and the Australian dollar is being punished as a result, falling below US56 cents and heading into territory last visited in 2001 in the wake of the tech crash and the Asian financial crisis when it hit a record low of US47.90c.

While a weak Australian dollar is good for Australian exports, softer global demand for trade given the virus may offset the benefits of lower exchange rates.

“As corporates face deteriorating economic conditions ... they will cut back on costs, namely staff, to protect their margins.

In terms of the impact on the broader economy, Yahyaei says businesses that require funding to sustain day-to-day operations may find it difficult to raise capital, contributing to higher default rates.

“As corporates face deteriorating economic conditions and a heightened risk of default, they will cut back on costs, namely staff, to protect their margins. The newly unemployed will reduce their consumption and this sort of action will further slow economic growth and the ‘negative wealth cycle’ will continue.”

In one instance, Qantas stood down two-thirds of its 30,000 employees until at least the end of May after grounding 150 of its aircraft.

Unconventional measures

Yahyaei says central banks are already dealing with interest rates close to zero, and are facing an ‘effective lower bound’ – the point in which the marginal effectiveness of conventional monetary operations may no longer stimulate the real economy.

“Most major economies are already undershooting inflation targets and any shock to the state of economic conditions may see deflationary pressures emerge where prices fall. They have resorted to unconventional monetary policies once more, most notably Quantitative Easing (QE).”

Another arm to monetary policy, other than reducing interest rates, is QE. This is when a central bank buys government bonds or other financial assets to provide liquidity to financial markets and to promote lower long-term interest rates, attempting to overcome the constraints posed by the effective lower bound. The aim is to stimulate demand and avoid deflationary pressures.

Hamid Yahyaei is a lecturer and Research Assistant in the Department of Applied Finance at Macquarie University.

Tough times ahead: Yahyaei, pictured, says businesses that require funding to sustain day-to-day operations may find it difficult to raise capital, contributing to higher default rates.

This prompted the Reserve Bank of Australia to hold an out-of-cycle emergency board meeting on March 19 where it cut interest rates to a record low and announced it would start pumping billions of dollars into the economy to keep it running.

As part of the measures, the central bank also launched a large bond-buying program and offered a multi-billion-dollar lending platform to banks and non-banks for small businesses.

“The RBA has introduced a range of measures that reflect all that they have learned over the past few years from unconventional policies implemented by the major central banks. Alongside the rate cut, they are now explicitly providing forward guidance on the path of the cash rate, attempting to fix yields on three-year government bonds in unity to the cash rate, and extending initial funding to Australian banks to the tune of around $90 billion,” Yahyaei says.

“Whether such unconventional policies can remedy these fears remains to be seen as markets are now facing an enemy that is not defined in any economics textbook.

“Policymakers have voiced demands requesting governments to enact fiscal policy and thus far they have responded with significant spending packages, including in Australia. Again, whether this can quell fears of a global recession remains to be seen.”

Hamid Yahyaei is a Specialised Lecturer and Research Assistant in the Department of Applied Finance at Macquarie Business School. He previously worked as a Senior Analyst at the Reserve Bank of Australia covering international financial markets and as a Credit Research Analyst at Spectrum Asset Management.


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