Covid-19 and the Financial System

Unfortunately, we're still in the early stages of the battle against the Covid-19 coronavirus, but we're slowly beginning to see data of its effects.  In the coming days, I'll collect and comment on data as it becomes available.  Let's begin with the effect on the financial system.  You probably know about the headline numbers (as of Mar 20): the S&P 500 is down 32% from its high, the Dow down about 35%, and the Russell 2000 down nearly 41%.  The yield on the ten-year US Treasury bond fell from just under 2% at the beginning of the year to less than 0.4% and currently is just under 0.9% (far below any time in US history).  The value of the dollar has soared against most currencies as global investors looked for a safe to put their money.  How much stress is there in financial markets?  Risk premiums for corporate bonds have jumped.  Below is a chart of the risk premium for the Baa corporate bond, which represents the extra amount investment-grade (safe) companies have to pay for credit.  Note that it has quickly jumped to its highest level since the financial crisis (from about 2% to 3.8% on Mar 18).

Another indicator of financial stress is the interest rate on TIPS (Treasury inflation-protected securities), which estimates the real interest rate (interest rate after adjusting for inflation).  Two main drivers of it are risk and demand for credit (typically resulting from increased economic activity).  Here's a chart showing its recent behavior:

You'll note that it was trending lower until early March before jumping from about -0.5% to 0.63%.  Is economic activity and demand for credit accelerating?  (no)  It reflects perceived risk.  I should note that this measure still doesn't compare to the spike in Fall 2008 during the depths of the financial crisis, but still is an indicator of fear about the financial system.

Normally, when there are concerns about the economy, investors shift their funds from stocks to bonds as well as other "safe" assets such as money market funds (and perhaps gold); as a result, stock prices go down while bond prices rise and yields decline.  Earlier this week, virtually all asset prices fell simultaneously (stocks, bonds, oil, precious metals) and there was increased pressure on money market mutual funds.  Together, this provides further evidence of extreme fear in the financial system (sell all assets to raise cash).  Fortunately, the Fed has taken extraordinary measures to try to stabilize the financial system.  There are too many to mention, but here's a link to how the Fed has responded so far: https://www.federalreserve.gov/covid-19.htm.