LONDON (Reuters) - If governments struggle to deliver adequate support for pandemic-hit economies during this second wave, even greater burden will fall back on central banks, and financial markets will have to price quickly for more monetary-policy contortions.
Despite all remaining “ifs” and “buts” and legal challenges surrounding this week’s still undecided U.S. election, markets are already racing in that direction.
The rationale is that the most likely outcome of Tuesday’s vote is policy gridlock in Washington between a Democrat-run Presidency and House and Republican-led Senate. This could leave fiscal policy shy of what’s needed to keep the economy moving through a second wave of the pandemic into 2021.
If that support splutters, while selective lockdowns hit activity again, the Federal Reserve will have to mobilize once more - with more bond-buying for sure, but possibly even rethinking its long-standing resistance to negative interest rates, or even moves toward a digital dollar down the line.
Differing political backdrops in Europe and elsewhere mean that the calculus varies across the world. But where the Fed goes may well dictate what others do in that regard - not least to avoid a damaging slide in the U.S. dollar’s exchange rate if the Fed were left to go solo.
Major central banks have been quick not to rule out any policy move during this shock, even though many - including the Bank of England and the Reserve Bank of Australia - insist negative interest rates are unlikely, or a last resort.
But that often assumes an environment of recovery from here, and crucially one where the Fed doesn’t join the European Central Bank and Swiss National Bank with sub-zero policy rates.
For all the different cross-currents, the sweep of market moves reacting to the U.S. election results on Wednesday and Thursday tally with that main thesis.
The big technology stocks that thrive on near-zero interest rates inflating discounted future cash flows have rocketed, driven partly by relief that gridlock in Washington will stymie any potential Democrat plan for regulatory and tax moves against them. Other sectors such as healthcare stocks have gone in the same direction.
“A Biden fiscal bonanza is now a long-shot having been a hot favourite theme on the eve of the election,” said Paul O’Connor, head of multi-asset at Janus Henderson Investors.
But other “long duration” - or highly interest rate sensitive assets - have followed higher, including long-maturity dollar and domestic currency sovereign and corporate debt around the world. Even recently subdued gold and bitcoin took off on Thursday.
Treasury bonds that had been betting for weeks on a Democrat clean sweep saw a sharp yield reversal on Wednesday.
And the dollar nosedived again - most obviously to two-year lows against the yuan as China’s economy re-emerges first from the pandemic and Beijing exhales on the likely removal from the White House of Trump, a persistent trade and diplomatic adversary.
Yet the likely greater pressure on the Fed has seen the dollar weaken more broadly across the world - against the euro, Japan’s yen and versus many emerging market currencies.
Bracing for another monetary wave, equity volatility measures have subsided across the horizon - and also showed how much “event-risk hedging” in options markets was built around just the day of the election itself.
A big question now is whether over-reliance on the Fed should be read so benignly by markets and whether the central bank has indeed run out of effective policy options - or at least options it’s willing to take.
Contrary to what many speculate, the price moves above are not dependent on inflation actually accelerating at all. Long-term inflation expectations in the bond market actually fell this week.
Societe Generale’s “perma bear” analyst Albert Edwards typically sees the glass as half empty, saying post-election markets simply realise the Fed will be asked to shoulder the burden again “much against its wishes”.
“If the U.S. government is about to enter an era of fiscal deadlock, this is likely to turn the final act in the Ice Age into a far bigger deflationary bust than I have been expecting,” he said, by “Ice Age” referring to his long-standing expectation of a protracted deflationary slump in the world economy.
Saxo Bank strategist John Hardy feels there really is no alternative to another major fiscal boost at this stage - even if that remains underclubbed for another two years.
“Some would argue that with Washington gridlock holding back fiscal stimulus potential for at least the next two years, the Fed can offset the downside risks by going ultra-easy,” Hardy wrote.
“But what can the Fed do from here besides increasing the pace of QE? Any demand side-effect would require the Fed to step outside of its mandate and innovate in ways never intended, and be highly politically charged.”
But the chances of even more extraordinary Fed moves over the next two years is a risk markets are inclined not to take lightly. If investors have learned one thing about central banking responses to the serial financial crises of the past 20 years, it’s never say “never”.
The opinions expressed here are those of the author, a columnist for Reuters.
by Mike Dolan, Twitter: @reutersMikeD. Editing by Pravin Char
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