Globally, central banks stepped up their emergency efforts to calm financial markets and support their economies as more of the world shuts down to contain the coronavirus outbreak.
- India’s central bank has decided to purchase sovereign notes maturing by 2025.
- Significance: The primary response to the virus is to manage the health of the population, but other arms of policy, including monetary and fiscal policy, play an important role in reducing the economic and financial disruption resulting from the virus
- Impact of coronavirus:
- Worst week for US markets since the 2008 global financial crisis: The Dow Jones Industrial Average plunged by 1,190.95 points — its largest single-day drop. The USA’s S&P 500 index was down 4% in early trade on Friday.
- The markets’ fear is about rate cuts by the U.S. Federal Banks as a response to the economic turmoil.
- Tokyo’s Nikkei, Seoul’s Kospi and European indices such as the FTSE 100 in London and Frankfurt’s DAX, were all down due to selling of shares.
- Benchmark Brent crude felled to as low as $50.51 a barrel.
- The commodity markets, metal prices fell by up to 6%.
- Global borrowings benchmark Libor fell to 1.46275%.
- Impact on bond-yields: The bond markets displayed an inverted yield curve where short-term bills yield more than long-term ones, signifying nervousness. An inverted yield curve signifies a recession.
- Impact on Indian markets: Sensex went down by 1,448.37 points. The rupee hit a six-month low against the dollar, at ₹72.27, before recovering marginally to close at ₹72.21.
- Impact on exports: Since India and China are major trading partners, a sharp hit to their exports and imports is likely.
- Export of commodities like ores (India exports 72% of its total ores to China), organic chemicals, cotton, etc. is likely to get hit if the disruption from the COVID-19 continues.
- RBI initiatives:
- Open market operations: The Reserve Bank of India enhanced the market liquidity with an additional bond purchase for as much as Rs.10,000 crore, as the corporate bonds and the Commercial Paper yields have risen.
- It will offer to buy four set of sovereign papers maturing between February 2022 and May 2025.
- Significance: The liquidity injection will help rationalise shorter term yields.
- Rate transmission issue: The move is significant as policy-rate reductions last year aren’t penetrating through the financial sector.
- Preference to govt. Bonds: the government risks crowding out corporate borrowers.
- Expansionary monetary policy by other central banks:
- The US Federal Reserve launched a programme to support money market mutual funds. The Fed has already slashed interest rates in two emergency moves
- The European Central Bank announced a €750 billion ($820 billion) bond-buying initiative.
- The Reserve Bank of Australia cut its benchmark interest rate by 25 basis points to 0.25% and ventured into quantitative easing with plans to purchase government bonds.
- Japan and South Korea also boosted bond-buying.
- The Philippine central bank cut its benchmark rate by a bigger-than-usual 50 basis points.
- Indonesia and Taiwan followed with 25-point reductions each. South Africa is also expected to ease policy later in the day.
- Dislocation across financial markets: Central bankers are scrambling to address liquidity shortages, financial stability risks and crushed growth prospects as whole cities go into lockdown and mass gatherings are increasingly banned to contain the virus.
- A global liquidity crunch: There is the mentality of “selling everything" except the US dollar, with huge liquidations and de-leveraging taking place everywhere.
- Destabiling exchange rates: The demand for dollars, together with the fall in oil prices has caused a devaluation of currencies.
- Extremely low interest rate environment due to global economic slowdown.
Why investors prefer govt. Issued bonds in slowdown?
- When an investor purchases a given corporate bond, they are actually purchasing a portion of a company's debt.
- Gilt-edged bonds refer to high-grade bonds that some national governments and private organizations issue in an effort to generate revenue.
- Gilt-edged securities are favored by investors who seek predictable returns, with little risk of default as the national governments rarely defaults.
About Bond yields and prices:
- The bond yield is the annual return on investment.
- It is dependent on the purchase price of the bond and the interest promised (coupon payment).
- A bond’s coupon rate is usually fixed, its price fluctuates due to changes in interest rates in the economy, demand, maturity period and credit quality.
- After issuance, bonds are traded at premiums or discounts to their face values until they mature and return to full face value.
- Example: Suppose a bond’s face value is Rs 1,000 on which an investor can earn 6%.
- This means that the coupon payment is 6% and an investor who buys the bond and holds it till maturity will get Rs 60 every year over the period of the bond.
- Suppose if the price of the bond drops in the market to Rs 980.
- That means the current yield is Rs 60 divided by Rs 980 = 6. 122%.
- If later, the price of the bond rises to Rs 1,030. That means the current yield is Rs 60 divided by Rs 1,030 = 5.8%.
- As the price of the bond fell, its yield increased.
About inverted yield curve
- It represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality.
- The yield curve is a graphical representation of yields on similar bonds across a variety of maturities.
- A normal yield curve slopes upward, reflecting the fact that short-term interest rates are usually lower than long-term rates. That is a result of increased risk premiums for long-term investments.
- When the yield curve inverts, short-term interest rates become higher than long-term rates.
- It is a predictor of economic recession.
- Recession is a slowdown in economic activities that may last for some quarters thereby completely hampering the growth of an economy. In such a situation, economic indicators such as GDP, corporate profits, employment, etc., fall.
Also read: Financial stability report