How will central banks respond?
Given how frail the recovery from the 2008 financial crisis has been and how vulnerable the global economy has recently looked, one would expect action from the major central banks at their upcoming policy meetings in March. Like its response in the aftermath of the Brexit referendum in 2016, the Bank of England may decide on a precautionary 0.25% cut. However, with the five-year swap rate falling to 0.44%, markets anticipate that the BoE might go further. EUR swap rates have reacted less strongly; unsurprising given how little room to manoeuvre the ECB has.
More remarkable is the sharp drop in US swap rates. Currently, the Fed Funds target rate is between 1.50% and 1.75%, whereas five year swap rates have now dipped below 0.9%. While markets had already been anticipating a rate cut by the Fed before the coronavirus crisis intensified, they are now expecting a lot more than that: short term interest rates are currently projected to fall below 0.6% by end of this year. Against this backdrop, it is worth recalling that the five year swap rate was trading around 1.75% only two months ago, and over 2.5% a year ago. By now dropping to such low levels, markets are suggesting that the Fed’s response will not only be forceful, but also permanent. If you assume that the short-term equilibrium real interest rate is 0%, the current five year swap rate implies average inflation to languish below 1% in the medium term – quite a pessimistic outlook.
But that might be a misinterpretation. Investors have shifted from equities into bonds and US yields had by far the most room to fall; hence the more pronounced drop in USD swap rates compared to those in sterling or euro. It is astonishing how demand for safe assets keeps pushing market interest rates ever lower. That said, if the economy’s fortune doesn’t turn out to be that bad after all and sentiment turns more optimistic again, USD swap rates are also likely to rebound the most. Considering this, USD borrowers may have just been offered a decent opportunity to lock in their interest rate exposure. Unfortunately, this could also amount to catching a falling knife.
