Markets learn hard way: don’t fight the RBA

In the AFR today I write that this was the official family’s finest hour—Australia’s own “Draghi moment”—where historic tensions between Scott Morrison’s government, the Reserve Bank of Australia, the corporate and banking regulators, and the banks dissolved as Team Australia came together to battle the greatest economic and human challenge the nation has faced since the Second World War. Click that link to read the full column or AFR subs can click here. Excerpt only:

Anyone who works in markets understands that this unprecedented and globally synchronised depression in demand and supply–wrought by an entirely alien pathogen–poses far greater hazards than the global financial crisis.

As I repeatedly explained in private communications with the government, the RBA, the banks, and other regulators in late February and early March, the source of this shock was “the inability of markets to price the extreme uncertainty inherent in a 1-in-100 year, deadly global pandemic, which is precipitating outright market failures that are killing liquidity, solvency and ultimately the global economy”.

“Again, this was predictable a week ago [as I had outlined] and is a classic case of Arrow's market failure due to extreme information asymmetries.”

“The businesses that die during this crisis are not coming back,” I continued, “and in contrast to every other crisis that we have experienced in modern market history, they are being crushed not due to some endogenous/internal financial error(s), but because of an entirely external shock in the form of a lethal pathogen that we have never seen before.”

The RBA’s former deputy governor, Stephen Grenville, claimed my analysis was wrong, alleging that “there have been a number of comparable epidemics”, and “if this one is having more impact, perhaps it is because financial markets have made themselves more fragile”.

Ironically, RBA governor Phil Lowe unwittingly put him in his place, retorting that “our communities and our financial markets are both having trouble dealing with a rapidly unfolding situation that they have not seen before”. The only precedent for the current pandemic is the Spanish Flu, which emerged over 100 years ago, when globally integrated and digitised markets did not exist.

In a March 7 analysis for the RBA and government, I wrote that “if ever there was a case for governments to provide a liquidity/economic ‘bridge’ between the current crisis and solutions in the near future in the form of effective anti-viral drugs, which look promising, and vaccines, it is right now. This is not about bailing-out bad businesses that have made mistakes, it is about keeping the global economy afloat as it tries to deal with the equivalent of a financial asteroid strike.”

While the central bankers took a few torturous weeks to come up to speed with the fact that all markets were breaking down, they have slowly, and iteratively, stepped up to the plate to defend the liquidity of the financial system and ensure borrowing costs for households and businesses remain low.

As recently as this week Grenville scoffed at my thesis that there was an emerging illiquidity and solvency crisis. “You talk about ‘a global liquidity crisis across both equity and bond markets’”, he wrote. “But equities and most bonds are still readily marketable. Government bonds are in such strong demand that yields are historically low.”

(I was, in fact, talking about the liquidity of government bonds and bank funding costs, and had expressly advised the RBA not to buy corporate bonds.)

On Thursday Governor Lowe stated that the RBA was being forced to intervene in the government bond market to “support its smooth functioning” because “liquidity conditions are highly stressed”. One major bank characterised it as “totally broken”.

The chair of the US Federal Reserve likewise confirmed that the US government bond market, supposedly the most liquid and risk-free of them all, had “shown signs of stress and impaired liquidity”. “When stresses arise in the Treasury market, they can reverberate through the entire financial system and the economy,” he warned.

In response to Grenville’s naïve remarks, one European trader snapped “show me a bid in German [government] bunds, because every time I try to sell liquidity disappears”.

As I forecast in my Financial Review column last week, Team Australia delivered precisely the optimal policy package for combatting the coronavirus crisis.

Read my full column on who Team Australia really involed here.