Private sector and deregulation to the rescue

Markets were very pleasantly surprised today when Trump unveiled a new public-private partnership designed to respond to the rapid and devastating spread of the coronavirus. Our federal government for too long has had an anti-business attitude as well as an unhealthy infatuation with regulations. This led, among other things, to severe and even absurd problems with tests for coronavirus. These problems were very clearly laid out in a great NY Times article that I referenced in my comments two days ago. Dan Mitchell of Cato yesterday added more meat to that article.

Federal regulations are simply not up to the task of designing and directing activities in a huge and complex economy like ours. The private sector, in contrast, is relatively adept at doing so. I think the market agrees, which is why stock prices surged 7% in the last hour as Trump's press conference unfolded.

Chart #1

This morning we likely saw the point of max panic. The Vix index surged to a new, recent high of 77.6, then closed down significantly at 57.8. The S&P 500 index opened a bit higher, then traded down to yesterday's low, which was almost 27% below its recent all-time high (i.e., a genuine bear market). But in the last hour prices surged as Trump unveiled a new approach to the coronavirus based on public-private partnerships and a serious and much-needed deregulation of the healthcare market's ability to innovate in times of emergency.

Chart #2

Chart #3

Charts #2 and #3 zoom in on the daily activity of the S&P 500 index and the Vix index (because it's a little hard to see in Chart #1). Yesterday, it now seems clear, was a day of maximum panic and pessimism. I felt sick to my stomach, and unable to imagine things ever getting better, and I'm sure many felt the same way. What a difference a day can make!

Chart #4

Chart #4 shows the daily action of high-yield credit default swap spreads, which are largely dominated these days by the bonds of energy producers. Spreads have soared in the past week or so, driven primarily by the abrupt plunge in oil prices. This added to the market's level of angst, since it greatly increased the risks of a cascade of bond defaults in the all-important energy sector. Trump's announcement at the press conference that the US will be taking advantage of cheap oil prices to fill the Strategic Petroleum Reserve saw these spreads contract almost immediately by 60 bps or so, which is the market's way of saying thanks. It's another demonstration of the power of market-based thinking: cheap oil prices present a great opportunity to buy, so why not have the government, with its gargantuan storage capacity, take advantage of the moment?

Not out of the woods yet

Markets are still very worried, and pricing is distressed. But no signs yet of a panic peak. Too many virus-related variables remain to be resolved. Here's a quick chart dump as of 10:30 PST:

Chart #1

Prices and fear are very close to their worst to date.

Chart #2

High, low, and closing price of the Vix index.

Chart #3

High, low, and closing price of the S&P 500 index.

Chart #4

Chart #4 shows that inflation expectations have plunged of late, as nominal yields have fallen while real yields are higher.

Chart #5

Chart #5 compares the real Fed funds rate (blue) with the market's expectation of what the real funds rate is likely to average over the next 5 years (red). The red line now exceeds the blue line, which means the real yield curve is once again positively-sloped, though not by much. The market expects the Fed to behave rationally in the face of a major decline in the price of oil. In other words, short-term interest rates are likely to decline by an amount roughly equal to the decline in headline CPI for a period.

Chart #6

Chart #6 shows how big swings in oil prices (blue) correspond to big swings in inflation expectations (red). 

Chart #7

Chart #7 shows how the big oil price declines of the mid-80s and mid-10s resulted in a significant, but temporary decline in headline inflation (blue). Underlying inflation was not much affected. We can expect to see a replay of these oil price shocks over the next year or so. Note that ex-energy inflation is currently running a solid 2+%. The Fed does not need to worry about inflation being too low. But a failure to cut rates as inflation falls would increase the real Fed funds rate, which is not called for given a virus-weakened economy.

UPDATE: as of 3pm EDT. It's getting VERY UGLY. The mood of the market could hardly be worse. The number of cases is shooting higher, deaths are mounting, air traffic is shutting down, public events are folding their tents, test kits are in very short supply in the U.S., it's a full-fledged global pandemic that can't be stopped, it's a real bear market ....  the Fed stepped in with both feet, but that only slowed the panic, nothing is going to work, we're all doomed .... there's no light at the end of this tunnel ....

If we aren't at max panic now, we're getting awfully close.

Chart #8

The current panic is right up there with some of the worst ever. The Vix index shot to over 100 briefly during the October 1987 crash, briefly hit 90 in late-2008, and registered a closing high of 80+ in November 2008 at the height of the financial panic. Back then, not only was the global economy in the grip of a deep recession, financial markets were melting down and big banks were evaporating. Today the markets are still functioning and there is plenty of liquidity. Yet the Vix is over 70 and rising.

Thoughts on market crashes

Back in October of 1987 I was one year into my job at Leland O'Brien Rubinstein (LOR), the firm that was later accused of having caused the biggest stock market crash in modern times (that's a story for another day). Sunday night, October 18th, I remember thinking "tomorrow is going to be very ugly." And indeed it was, as the stock market went on to lose more than one-third of its value in the span of just two months. Last night I thought the same, and this morning the market opened almost 20% below its all-time high registered a bit less than 3 weeks ago.

The Crash of October 1987 shocked the world, but—to me—the most surprising result of all the angst and turmoil was that it didn't precipitate a recession. Indeed, real GDP growth in Q4/87 was a rather spectacular 7%. There's a lot of fear behind the current selloff, but there is also something tangible to worry about, and that is of course the potential of a teeny-tiny virus to upset—and possible even to derail—the global economy. Back in 1987 it seemed inconceivable that we would avoid a recession, and it seems that way now too.

Today's Vix index didn't exist in 1987, but I recall that calculations of implied stock market volatility at its peak were in the neighborhood of 100+. Earlier this morning the Vix shot up to 62, but it's still lower than the all-time high of 90, which was registered in October 2008. We're not at record levels of panic yet, but we're pretty close, and so far the number of American victims of the virus is practically de minimis, but sure to soar.

Scientists are working furiously on vaccines and therapeutics. Markets are consumed with risk sharing—those willing to bear downside risk are being compensated handsomely, while those with low risk tolerances are locking in huge losses. Liquid markets act as shock absorbers for the physical economy, and there is no sign to date that liquidity is drying up. Central banks are supplying needed liquidity, and another round of Quantitative Easing seems like a no-brainer. Fiscal policy, however, is a clumsy tool at times like this; better to let market pricing solve problems by directing resources to their highest and best use.

How all of this sorts in the next few days and weeks is anybody's guess. But it's a sure bet that we are nowhere near the end of the world as we know it.

Here are some relevant charts with prices as of 12:30 pm Eastern time:

Chart #1

The current decline in stock prices seems tame compared to other periods of panic.

Chart #2

Short-term interest rates have collapsed to near-zero. The demand for safe assets is intense.

Chart #3

Credit spreads have jumped, similar to what happened when oil prices collapsed in 2015-16. The market is concerned that sharply lower oil prices will bankrupt many oil producers.

Chart #4

Systemic risk is still relatively low, especially in the U.S. market, and liquidity is still abundant. Markets are not freezing up as they did in late-2008. That is a very good sign.

Chart #5

The dollar today is pretty close to its average over the past 5 years, and nowhere near being dangerously weak nor worrisomely strong. Oil prices have suddenly become cheap again. Good for consumers, bad for producers. In any event, we've lived through this sort of thing before and the world didn't end.

Chart #6

The Vix jumped to 62 at the open, and is currently trading at 53 or so. Options on stocks are extremely expensive for those who want to minimize risk, and extremely attractive for those willing to bear risk. This is the proper function of markets—using prices to shift risk to those who are willing to bear it.