U.S., China market rescues may be risky for investors

Fear of the coronavirus hit Chinese markets hard in the form of a one- day eightper-cent selloff just after the markets reopened from a layoff for Lunar New Year festivities. With residents of multiple cities confined to their homes and city centres shut down, a deeper and more painful selloff appeared to be a surety. But then the country’s central bank came to the rescue.

The People’s Bank of

China immediately injected US$ 174 billion of liquidity into the markets through reverse repos and cut the seven- day interest rate to 2.4 per cent from 2.5 per cent. The central bank has also said it will issue loans totalling US$ 43 billion to companies working to fight the virus that has killed more than 900 and affected 40,000 worldwide.

Since the PBOC stepped in, the Shenzhen Component Index has more than recovered its losses and eclipsed its pre- Lunar New Year levels. The Shanghai Composite Index, meanwhile, is only down three per cent during the same timeframe.

“They’re really bringing out the big guns,” said Stephen Innes, who trades in China and is the chief market strategist at Axicorp. “( But) we’re pretty concerned here, just as people are concerned in the U. S. about the ( U. S. Federal Reserve) pumping too much for too long.”

Central banks in China and the United States have both adopted more interventive policies that have kept their markets out of danger. In 2019 alone, the Fed cut rates three times and spent hundreds of billions of dollars to supercharge the repo markets, where central banks buy assets such as government bonds from financial institutions and sell them back for an increased price to create temporary liquidity.

Such a tactic might work in the short term, but there are potential risks associated with bailing out the market, whether it’s in China or the U.S.

Capital Economics chief economist Neil Shearing in a note published Monday said the U.S. is in a Goldilocks environment where low interest rates align with low but positive growth. Remaining in this environment for too long, he said, could cause interest rates to unexpectedly rise and undermine asset valuations that have risen during the U. S.’s longest bull market in history.

In another scenario, the economic environment convinces investors to forge ahead in a “hunt for yield” that causes a “melt- up,” where prices continue to inflate until market bubbles burst. The last time this occurred was when the housing bubble burst in 2008. Before that, it was the dot-com bubble in the early 2000s.

Inflation is another concern, according to Shearing.

The Fed’s inflation rate target is two per cent, although some market watchers have argued that number might be the floor and not the ceiling. Should inflation run up too high, too quickly, he said it might force a policy response in the form of a rate hike.

That scenario, Shearing said, would mirror the Fed’s decision to tighten policy in the early 1980s to relieve itself of inflationary risks. As a result, the U. S. entered a recession.

In both the U. S. and China, these solutions do not amount to much more than papering over the market’s cracks, Innes said. It leaves investors happy while stretching the business cycle out to delay a recession.