The Three Phases of the Covid Crash
Updated: Jul 3
From around 21 February 2020, markets gradually begin to grasp the seriousness of the Covid-19 problem. Equities started to weaken and US Treasuries rallied, exactly as we would expect. The dollar weakened, largely driven by the fact that US bond yields started at 1.5% and had much further to fall versus other major government bond yields. The Fed offers soothing words and promises at “act as appropriate” and cuts rates by 0.5% on 3 March, but otherwise business as usual.
Equity markets are in freefall but this time, instead of rallying on safe haven buying, the US bond market (the benchmark risk-free asset) is also collapsing. On an intraday basis, the TLT, which is the ETF that tracks long-term Treasuries, the benchmark risk-free asset fell 22% in eight trading days.
Simultaneously, the US dollar is screaming higher. This is nothing like what is supposed to happen. It was all fun and games while it was just the stock market but once the Treasury market came under pressure, the Fed went full shock and awe.
The Fed kept going, launching program after program and supplying dollar liquidity until the dollar retreated, bonds recovered, and equities began a substantial rally. Since that moment, a degree of calm has remained.
This chain of events is highly informative. The current dollar-based monetary system means there are huge dollar-denominated debts outside the US. As economies around the world began to shut down, they needed dollars to service those debts.
The chart above shows that the US has a massively negative Net International Investment Position at around 50% of GDP (c. $11tn). This means foreigners own $11tn more of US assets than the US owns of overseas assets. Roughly speaking, foreigners own $40tn of US assets versus $29tn of foreign assets owned by the US. This is the cumulative result of the trade deficits that the US has been running in recent years.
Faced with a dollar shortage to meet liabilities in the face of a collapse of dollar revenues (think commodity exporting countries), they did the only thing they could – they started selling US assets, including Treasuries.
The chart of US TIC data below shows that in March, foreigners sold a net $300bn of the world’s ultimate risk-free asset during the greatest risk-off event in living memory.
It also shows that after being massive, consistent buyers of Treasuries in the first 15 years of the millennium, foreigners haven’t been net buyers of US debt for five years. The importance of this fact becomes clear when we think of the budget deficit the US has already been running for some time and that it is now going to explode higher. Not only is the Fed going to have to buy the lion’s share of the trillions of new debt coming out of the Treasury, but unless they provide access to the dollars required in the wider world and in a timely fashion, the selling pressure in assets will resume. If they don’t, the US dollar will scream higher and asset prices will collapse. If they do, then risk assets can continue to perform despite the horrendous economic backdrop. Given what’s at stake, it feels like they have little choice.